Question

Rhone-Metro Industries manufactures equipment that is sold or leased. On December 31, 2018, Rhone-Metro leased equipment to Western Soya Co. for a four-year period ending December 31, 2022, 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, 2022, is not guaranteed. Equal payments under the lease are $104,000 (including $4,000 maintenance costs) and are due on December 31 of each year. The first payment was made on December 31, 2018. 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. (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 $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)?
3. Prepare the appropriate entries for both Western Soya Co. and Rhone-Metro on December 31, 2018.
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, 2019 (the second lease payment and amortization).
6. Prepare the appropriate entries for both Western Soya and Rhone-Metro on December 31, 2022, assuming the equipment is returned to Rhone-Metro and the actual residual value on that date is $1,500.

Answer 1

Answer 1.
Let X = Amount of each annual payment
PV of annual payments: Table 6, 4 payments @ 10% = 3.48685 x X
PV of guaranteed residual value: Table 2, 4 periods @ 10% = .68301 x
$25,000 = $17,075
3.48685X + $17,075 = $365,760
3.48685X = $348,685
X = $348,685 ÷ 3.48685 = $100,000
Total Annual Lease Payament = $100,000 + 4000 (Executory Costs) = $104000
Answer 2.
Lessee and Lessor Criteria:
1. Title transfer? No
2. Bargain purchase option? No
3. Lease term ≥ 75% of asset useful life? No, it is 66.7% (4 ÷ 6)
4. PVMLP ≥ 90% FMV? Yes, it is 100% ($365,760 ÷ $365,760)
Additional Lessor Criteria
1. Collectibility of the minimum lease payments is reasonably assured?    Ye s
2. Any lessor costs yet to be incurred are reasonably predictible? Yes
Therefore: Capital lease for lessee because it meets the 4th criterion.
Direct financing lease for lessor. It meets the 4th criterion common to both the lessee and lessor, as well as both of the lessor specific criteria. It is direct financing because cost equals fair market value.
Answer 3.
Western Soya Co. (Lessee)
Leased asset	365,760
Lease payable		365,760
Lease payable	100,000
Executory Cost	4,000
Cash		100,000
Rhone-Metro (Lessor)
Lease receivable	365,760
Equipment		365,760
Cash	104,000
Lease receivable		100,000
Executory Cost		4000

Answer 4.
Both will use the same table:
Date	Payment	Interest @10%	Principal	Balance
12/31/2016			0	365,760
12/31/2016	100,000	-	100,000	265,760
12/31/2017	100,000	26,576	73,424	192,336
12/31/2018	100,000	19,234	80,766	111,570
12/31/2019	100,000	11,157	88,843	22,727
12/31/2020	25,000	2,273	22,727	-