Question

In: Accounting

Pharoah Industries and Novak Inc. enter into an agreement that requires Novak Inc. to build three...

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.

Solutions

Expert Solution

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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