Pharoah Industries and Novak Inc. enter into an agreement that requires Novak In

Question

Pharoah Industries and Novak Inc. enter into an agreement that requires Novak Inc. to build three diesel-electric engines to Pharoah’s specifications. Upon completion of the engines, Pharoah has agreed to lease them for a period of 10 years and to assume all costs and risks of ownership. The lease is noncancelable, becomes effective on January 1, 2017, and requires annual rental payments of $431,633 each January 1, starting January 1, 2017.

Pharoah’s incremental borrowing rate is 10%. The implicit interest rate used by Novak Inc. and known to Pharoah is 8%. The total cost of building the three engines is $2,693,000. The economic life of the engines is estimated to be 10 years, with residual value set at zero. Pharoah depreciates similar equipment on a straight-line basis. At the end of the lease, Pharoah assumes title to the engines. Collectibility of the lease payments is reasonably certain; no uncertainties exist relative to unreimbursable lessor costs.

(b) Prepare the journal entry or entries to record the transaction on January 1, 2017, on the books of Pharoah Industries. (c) Prepare the journal entry or entries to record the transaction on January 1, 2017, on the books of Novak Inc (d) Prepare the journal entries for both the lessee and lessor to record the first rental payment on January 1, 2017 -Prepare the journal entries for both the lessee and lessor to record interest expense (revenue) at December 31, 2017. Show the items and amounts that would be reported on the balance sheet (not notes) at December 31, 2017, for both the lessee and the lessor.

Explanation / Answer

Journal Entries Date Account Title & Explantation Debit Credit Part-b Entry in The Books of Pharoah Industries 01 Jan2017 Lease Engine Under Capital Lease $3,127,997 Lease Liability $3,127,997 Part-C Entry in The Books of Novak Inc. 01 Jan2017 Lease Receivable $3,127,997 Cost of Goods Sold $2,693,000 Sales $3,127,997 Inventory $2,693,000 Part-d (i): Entry in the books of Pharoah Industries ( Lessee) 01 Jan2017 Lease Liability $431,633 Cash $431,633 Part-d (ii): Entry in the books of Novak Inc. ( Lesser) 01 Jan2017 Cash $431,633 Lease Receivable $431,633 Part-e (i): Entry in the books of Pharoah Industries ( Lessee) 31-Dec-17 Interest Expense $215,709 Interest Payable $215,709 Part-e (ii): Entry in the books of Novak Inc. ( Lesser) 31-Dec-17 Interest Receivable $215,709 Interest Revenue $215,709 Pharoah Industries Balancesheet   31 December 2017 Property/Plant/Equipment Current Liabilities Lease Under Capital Lease $3,127,997 Interest Payable $215,709 Lease Accumulated Depreciation $312,799.70 Lease Liability $215,924 ( $31279971/10 Year) $2,815,197.30 Long Term Liabilities Lease Liabilities $2,480,440 Working Note-1 : Computation of Present Value of Lease Payment Detail Amount Time PVF @8% Present Value Annual Lease Rental $431,633 1-10 7.24689 $3,127,997 Total Present Value ( Rounded by $1) $3,127,997 Working Note-2 Computation of Dealer Profit Detail Amount Sales ( present Value of Lease Payment) $3,127,997 Less: Cost of Engine Devlopment $2,693,000 Profit on Sales $434,997 Working Note-3: Amortisation Schedule Date Annual Lease Receipt/Payment Interest on Receivable/Liability at 8% Reduction in Receivable/Liability Lease Receivable /Liability 01/01/2017 $3,127,997 01/01/2017 $431,633 $431,633 $2,696,364 01/01/2018 $431,633 $215,709 $215,924 $2,480,440 01/01/2019 $431,633 $198,435 $233,198 $2,247,242

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