Question

Rhone-Metro Industries manufactures equipment that is sold or leased. On December 31, 2013, Rhone-Metro leased equipment to Western Soya Co. for a four-year period ending December 31, 2017, at which time possession of the leased asset will revert back to Rhone-Metro. The equipment cost $300,000 to manufacture and has an expected useful life of six years. Its normal sales price is $365,760. The expected residual value of $25,000 at December 31, 2017, is not guaranteed. Equal payments under the lease are $104,000 (including $4,000 executory costs) and are due on December 31 of each year. The first payment was made on December 31, 2013. Collectibility of the remaining lease payments is reasonably assured, and Rhone-Metro has no material cost uncertainties. Western Soya’s incremental borrowing rate is 12%. Western Soya knows the interest rate implicit in the lease payments is 10%. Both companies use straight-line depreciation.

Required:

1. Show how Rhone-Metro calculated the $104,000 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)? Why?

3. Prepare the appropriate entries for both Western Soya Co. and Rhone-Metro on December 31, 2013.

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, 2014 (the second lease payment and depreciation).

6. Prepare the appropriate entries for both Western Soya and Rhone-Metro on December 31, 2017, assuming the equipment is returned to Rhone-Metro and the actual residual value on that date is $1,500.

Answer 1

Requirement 1

Lessor’s Calculation of Lease payments

* Present value of $1: n = 4, i = 10%

** Present value of an annuity due of $1: n = 4, i = 10%

Requirement 2

The lessee’s incremental borrowing rate (12%) is more than the lessor’s implicit rate (10%). So, both parties’ calculations should be made using a 10% discount rate:

Application of Classification Criteria
1 Does the agreement specify that
ownership of the asset transfers
to the lessee?	NO
2 Does the agreement contain a
bargain purchase option?	NO
3 Is the lease term equal to 75%
or more of the expected	NO
economic life of the asset?	{4 yrs<75% of 6 yrs}
4 Is the present value of the
minimum lease payments equal
to or greater than 90% of the	YES
fair value of the asset?	{$348,685a > 90% of $365,760}
a See calculation below.

 

Present Value of Minimum Lease Payments
Present value of periodic lease payments excluding
executory costs of $4,000	($100,000* × 3.48685**)	$348,685
** Present value of an annuity due of $1: n = 4, i = 10%

* Since the residual value is not guaranteed, it is excluded from both the lessor’s and the lessee’s minimum lease payments and therefore does not affect the 90% of fair value test.

(a) by Western Soya Co. (the lessee)

Since at least one criterion is met, this is a capital lease to the lessee. Western Soya records the present value of minimum lease payments as a leased asset and a lease liability.

(b) by Rhone-Metro (the lessor)

Since the fair value exceeds the lessor’s carrying value, the equipment is being “sold” at a profit, making this a sales-type lease:

Fair value	$365,760
minus
Carrying value	(300,000)
equals
Dealer’s profit	$ 65,760

Requirement 3

December 31, 2013
Western Soya Co. (Lessee)
Leased equipment (calculated above)	348,685
Lease payable (calculated above)		348,685
Lease payable	100,000
Prepaid operating expense (2014 expenses)	4,000
Cash (lease payment)		104,000
Rhone-Metro (Lessor)
Lease receivable (fair value)	365,760
Cost of goods sold ($300,000 – [$25,000 × .68301])	282,925
Sales revenue ($365,760 – [$25,000 × .68301])		348,685
Inventory of equipment (lessor’s cost)		300,000
Cash (lease payment)	104,000
Payable (maintenance, insurance, etc.)		4,000
Lease receivable		100,000

Requirement 4

Lessee (unguaranteed residual value excluded):

Lease Amortization Schedule
		Effective			Decrease	Outstanding
Dec.	Payments	Interest			in Balance	Balance
31		10% × Outstanding Balance
2013						348,685
2013	100,000				100,000	248,685
2014	100,000	.10 (248,685)	=	24,869	75,131	173,554
2015	100,000	.10 (173,554)	=	17,355	82,645	90,909
2016	100,000	.10 (90,909)	=	9,091	90,909	0
	400,000			51,315	348,685

Lessor (unguaranteed residual value included):

Lease Amortization Schedule
		Effective			Decrease	Outstanding
Dec.	Payments	Interest			in Balance	Balance
31		10% × Outstanding Balance
2013						365,760
2013	100,000				100,000	265,760
2014	100,000	10 (265,760)	=	26,576	73,424	192,336
2015	100,000	10 (192,336)	=	19,234	80,766	111,570
2016	100,000	10 (111,570)	=	11,157	88,843	22,727
2017	25,000	10 (22,727)	=	2,273	22,727	0
	425,000			59,240	365,760

Requirement 5

December 31, 2014
Western Soya Co. (Lessee)
Depreciation expense ($348,685 ÷ 4 years)	87,171
Accumulated depreciation		87,171
Operating expense (2014 expenses)	4,000
Prepaid operating expense (paid in 2013)		4,000
Interest expense (10% × [$348,685 – 100,000])	24,869
Lease payable (difference)	75,131
Prepaid operating expense (2015 expenses)	4,000
Cash (lease payment)		104,000
Rhone-Metro (Lessor)
Cash (lease payment)	104,000
Payable (maintenance, insurance, etc.)		4,000
Lease receivable (difference)		73,424
Interest revenue (10% × [$365,760 – 100,000])		26,576

Requirement 6

December 31, 2017
Western Soya Co. (Lessee)
Operating expense (2017 expenses)	4,000
Prepaid operating expense (paid in 2016)		4,000
Depreciation expense ($348,685 ÷ 4 years)	87,171
Accumulated depreciation		87,171
Accumulated depreciation (account balance)	348,685
Leased equipment (account balance)		348,685
Rhone-Metro (Lessor)
Inventory of equipment (actual residual value)	1,500
Loss on leased assets ($25,000 – 1,500)	23,500
Lease receivable (account balance)		22,727
Interest revenue (10% × $22,727: from schedule)		2,273