Question

Rhone-Metro Industries manufactures equipment that is sold or leased. On December 31, 2021, Rhone-Metro leased equipment to Western Soya Co. for a four-year period ending December 31, 2025, at which time possession of the leased asset will revert back to Rhone-Metro. The equipment cost $520,000 to manufacture and has an expected useful life of six years. Its normal sales price is $586,259. The expected residual value of $30,000 at December 31, 2025, is not guaranteed. Equal payments under the lease are $166,000 (including $6,000 maintenance costs) and are due on December 31 of each year. The first payment was made on December 31, 2021. Western Soya’s incremental borrowing rate is 12%. Western Soya knows the interest rate implicit in the lease payments is 9%. Both companies use straight-line depreciation. (FV of $1, PV of $1, FVA of $1, PVA of $1, FVAD of $1 and PVAD of $1) (Use appropriate factor(s) from the tables provided.)

Required:

1. Show how Rhone-Metro calculated the $166,000 annual lease payments.
2. How should this lease be classified (a) by Western Soya Co. (the lessee) and (b) by Rhone-Metro Industries (the lessor)?
3. Prepare the appropriate entries for both Western Soya Co. and Rhone-Metro on December 31, 2021.
4. Prepare an amortization schedule(s) describing the pattern of interest over the lease term for the lessee and the lessor.
5. Prepare the appropriate entries for both Western Soya and Rhone-Metro on December 31, 2022 (the second lease payment and amortization).
6. Prepare the appropriate entries for both Western Soya and Rhone-Metro on December 31, 2025, assuming the equipment is returned to Rhone-Metro and the actual residual value on that date is $1,500.

Answer 1

1. Calculation of annual lease payment

Year	Payment	Discount Factor @ 9%	Present Value
31-12-2021	160,000	1	$160,000
31-12-2022	160,000	0.9174	$146,789
31-12-2023	160,000	0.8417	$134,669
31-12-2024	160,000	0.7722	$123,549
31-12-2025	30,000	0.7084	$21,252
		Total	$586,259

From the above calcuation we can see that total present value of lease rentals and residual value at 9% is equal to current purchase price i.e. $586,259. Accordingly annual lease rental shall be $160000 + annual maintenance costs i.e. $6000.

2. Finance lease is a lease where all right and obligations attached to the asset transfered to lessee from the lessor. Where lease term covers major part of useful life of asset then such asset shall be classified as finance lease.

Hence this lease transaction shall be classified as finance lease by Western Soya Co. (the lessee) and it shall be classified as sale by Rhone-Metro Industries (the lessor).

3. Journal Entries on December 31, 2021

In the books of Western Soya Co. (the lessee)
Leasehold Asset Account			Dr.	564,704
To Leasehold obligation Account (Rhone-Metro Industries)			564,704
Leasehold obligation Account (Rhone-Metro Industries)	Dr.	160,000
To Bank Account					160,000
In the books of Rhone-Metro Industries (the lessor)
Western Soya Co. Account			Dr.	586,259
To Sale of asset on lease Account				586,259
Bank Account				Dr.	160,000
To Western Soya Co. Account				160,000

3. Amortization schedule(s) describing the pattern of interest over the lease term for the lessee

Year	Opening Balance	Interest @12%	Payment	Closing Balance
31-12-2021	$          564,704	$                      -	$          166,000	$          398,704
31-12-2022	$          398,704	$             47,844	$          166,000	$          280,548
31-12-2023	$          280,548	$             33,666	$          166,000	$          148,214
31-12-2024	$          148,214	$             17,786	$          166,000	$                      -
31-12-2025

Amortization schedule(s) describing the pattern of interest over the lease term for the lessor

Year	Opening Balance	Interest @9%	Payment	Closing Balance
31-12-2021	$          586,259	$                      -	$          160,000*	$          426,259
31-12-2022	$          426,259	$             38,363	$          160,000*	$          304,622
31-12-2023	$          304,622	$             27,416	$          160,000*	$          172,038
31-12-2024	$          172,038	$             15,483	$          160,000*	$             27,522
31-12-2025	$             27,522	$               2,478	$             30,000	$                      -

*$160000=$166000-$6000

5. Journal Entries on December 31, 2020

In the books of Western Soya Co. (the lessee)
Finance Charges Account			Dr.	$          47,844
To Leasehold obligation Account (Rhone-Metro Industries)			$          47,844
Depreciation Account ($564703/4 years)		Dr.	$        141,176
To Leasehold Asset Account			$        141,176
Leasehold obligation Account (Rhone-Metro Industries)	Dr.	$        166,000
To Bank Account					$        166,000
In the books of Rhone-Metro Industries (the lessor)
Western Soya Co. Account			Dr.	$          38,363
To Finance Income Account				$          38,363
Bank Account				Dr.	$        160,000
Bank Account (Maintenance Expenses)		Dr.	$            6,000
To Western Soya Co. Account				$        166,000

6.  Appropriate entries for both Western Soya and Rhone-Metro on December 31, 2025, assuming the equipment is returned to Rhone-Metro and the actual residual value on that date is $1,500

In the books of Western Soya Co. (the lessee)
Depreciation Account ($564703/4 years)		Dr.	$        141,176
To Leasehold Asset Account			$        141,176
In the books of Rhone-Metro Industries (the lessor)
Western Soya Co. Account			Dr.	$            2,478
To Finance Income Account				$            2,478
Bank Account (actual residual value)		Dr.	$            1,500
Loss on lease Account (Transfer to Profit & Loss Account)	Dr.	$          28,500
To Western Soya Co. Account				$          30,000