Question

On December 31, 2021, Rhone-Metro Industries 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 Rhone-Metro $672,747 and has an expected useful life of six years. Its normal sales price is $672,747. The lessee-guaranteed residual value at December 31, 2025, is $15,000. Equal payments under the lease are $190,000 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 10%. Both companies use straight-line depreciation. Use (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 $190,000 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 all 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 $2,000.

Answer 1

1	Computation of annual lease payment:
	Incremental borrowing rate (12%) > Interest rate implicit in the lease (10%)
	Discount rate=interest rate implicit in the lease=10%
	Lease term=4 years
							$
	Normal selling price						672747
	Less: Present value of residual value at 10% for 4 years
	(15000*0.68301)						10245
	Present value of periodic lease payment				a		662502
	Present value @ 10% for 4 years				b	(Note:1)	3.48685
	Periodic lease payment						190000
	First lease payment is on the inception of lease
	Hence, discount factor for first year will be 1.
	Year	Discount factor
	0	1
	1	0.90909
	2	0.82645
	3	0.75131
	Total	3.48685
2
a)	Present value of minimum lease payment=Normal selling price=$ 672747
	Hence, we can classify this lease as capital lease
b)	Normal selling price=Cost of the equipment=$ 672747
	Hence, it is a direct financing lease since there is no dealer's profit involved
3	Western soya co. (Lessee)
	Date	General Journal				Debit	Credit
	Dec 31,2021	Leased equipment				672747
		Lease payable					672747
		(Lease recorded)
		Lease payable				190000
		Cash					190000
		(First lease payment made)
	Rhone metro (Lessor)
	Date	General Journal				Debit	Credit
	Dec 31,2021	Lease receivable				672747
		Equipment					672747
		(Lease recorded)
		Cash				190000
		Lease receivable					190000
		(First lease payment received)
4		Lease amortization schedule
	Date	Lease payment	Interest expense	Decrease in lease payable	Lease payable
		a	b=(Lease payable * 10%)	c=a-b	d=prev. balance-c
	Dec 31,2021				672747
	Dec 31,2021	190000	0 *	190000	482747
	Dec 31,2022	190000	48275	141725	341022
	Dec 31,2023	190000	34102	155898	185124
	Dec 31,2024	190000	18512	171488	13636
	Dec 31,2024	15000	1364	13636	0
	* Since payment made at the inception of lease, no interest expense
	Residual value=$ 15000
5	Western soya co. (Lessee)
	Date	General Journal				Debit	Credit
	Dec 31,2022	Interest expense				48275
		Lease payable				141725
		Cash					190000
		(Second lease payment made)
		Depreciation expense			(Note:1)	164437
		Accumulated depreciation					164437
		(Depreciation recorded)
	Rhone metro (Lessor)
	Date	General Journal				Debit	Credit
	Dec 31,2022	Cash				190000
		Lease receivable					141725
		Interest revenue					48275
		(second lease payment received)
	Note:1
	Depreciation under straight line method=(Cost-residual value)/Useful life of the asset
	Here, useful life of asset=Lease term=4 years
	Depreciation under straight line method=(672747-15000)/4=$ 164437