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Atwater Equipment Co. manufactures, sells, and leases heavy construction equipment. England Construction Company, a regular customer, leased equipment on July 1, 2011, that had cost Atwater $252,000 to manufacture. The lease payments are $63,161, beginning on July 1, 2011, and continuing annually with the last payment being made on July 1, 2015. If England were to purchase the equipment outright, the fair value would be $291,881. Because of the heavy wear expected on construction equipment, the lease contains a guaranteed residual value clause wherein the lessee guarantees a residual value on June 30, 2016, of $65,000. England contracted with Weathertop Financial Services to serve as a third-party guarantor of the residual value. Atwater?s implicit interest rate is 12%, which is lower than England?s incremental borrowing rate of 14%.
Instructions:
1. Assuming that the equipment reverts to Atwater upon completion of the lease term and that the equipment has an expected useful life of 10 years, prepare the entries that should be made on the books of both Atwater and England in recording the lease on July 1, 2011. (Note: England knows the implicit interest rate for the lease.)
2. Prepare the journal entries that should be made by Atwater and England on July 1, 2012. Ignore fiscal year considerations.
3. What financial statement disclosure should be made by Weathertop in its role as a third-party guarantor?
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