Stellar Industries and Pearl Inc. enter into an agreement that requires Pearl In

Question

Stellar Industries and Pearl Inc. enter into an agreement that requires Pearl Inc. to build three diesel-electric engines to Stellar’s specifications. Upon completion of the engines, Stellar 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 $413,143 each January 1, starting January 1, 2017.

Stellar’s incremental borrowing rate is 10%. The implicit interest rate used by Pearl Inc. and known to Stellar is 8%. The total cost of building the three engines is $2,579,000. The economic life of the engines is estimated to be 10 years, with residual value set at zero. Stellar depreciates similar equipment on a straight-line basis. At the end of the lease, Stellar 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 Stellar Industries. (Credit account titles are automatically indented when amount is entered. Do not indent manually. If no entry is required, select "No Entry" for the account titles and enter 0 for the amounts. Round present value factor calculations to 5 decimal places, e.g. 1.25124 and the final answer to 0 decimal places e.g. 58,971.)

(c) Prepare the journal entry or entries to record the transaction on January 1, 2017, on the books of Pearl Inc. (Credit account titles are automatically indented when amount is entered. Do not indent manually. If no entry is required, select "No Entry" for the account titles and enter 0 for the amounts. Round answers to 0 decimal places e.g. 58,971.)

(d) Prepare the journal entries for both the lessee and lessor to record the first rental payment on January 1, 2017. (Credit account titles are automatically indented when amount is entered. Do not indent manually. If no entry is required, select "No Entry" for the account titles and enter 0 for the amounts.)

Prepare the journal entries for both the lessee and lessor to record interest expense (revenue) at December 31, 2017. (Credit account titles are automatically indented when amount is entered. Do not indent manually. If no entry is required, select "No Entry" for the account titles and enter 0 for the amounts.)

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

Since, there are multiple parts to the question and some parts have subparts, I have answered the first 4 parts.

_______

Part b)

To prepare the journal entry, we need to calculate the present value of lease payments as below:

Present Value of Lease Payments = Annual Lease Payment*PVIFA(8%,10 Years) = 413,143*7.24689 = $2,994,000 [where PVIFA indicates Present Value Interest Factor for an Annuity Due]

Now, we can prepare the journal entry as below:

______

Part b)

The journal entry on the books of Pearl Inc. is given as follow:

_____

Part d)

The journal entry to record the first rental payment in the books of lessee and lessor is prepared as below:

Lessee:

_____

Lessor:

_____

Part e)

To prepare the journal entry to record interest expense (revenue) at December 31, 2017, we need to determine the value of interest amount as below:

Interest Amount = Implicit Rate*(Present Value of Lease Payments - Annual Lease Payment for Year 1) = 8%*(2,994,000 - 413,143) = $206,469

Now, we can prepare the journal entry as below:

Lessee:

_____

Lessor:

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