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 noncancelable stated lease term of four years ending December 31, 2025, at which time possession of the leased asset will revert back to Rhone-Metro. The equipment cost $400,000 to manufacture and has an expected useful life of six years. Its normal sales price is $457,779. The expected residual value of $28,000 on December 31, 2025, is not guaranteed. Western Soya Co. is reasonably certain to exercise a purchase option on December 30, 2024, at an option price of $12,000. Equal payments under the lease are $171,000 (including $4,000 annual 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 14%. Western Soya knows the interest rate implicit in the lease payments is 12%. Both companies use straight-line amortization.


Hint: A leasing term ends for accounting purposes when an option becomes exercisable if it’s expected to be exercised (i.e., a BPO). (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 $171,000 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 rent payment and amortization).
6. Prepare the appropriate entries for both Western Soya and Rhone-Metro on December 30, 2024, assuming the purchase option is exercised on that date.

Answer 1

1. Show how Rhone-Metro calculated the $171,000 annual lease payments.

Answer:

Unguaranteed Residual Value
	PV of $1
n	3
I (%)	12%
	Present Value
Amount to be recovered	457,779
Less: PV of bargain Purchase option	8,541
Amount to be recovered by periodic payments	449,238
Lease Payments
	PVAD of $1
n	3
I (%)	12%
	Lease Payments
Lease payment of beginning of each year	$167,000
Add: Maintanence Cost	4,000
Lease payment including maintenance costs	$171,000

Calculation

First we need to calculate the PV factor. That will be:

Present value Interest factor :

n = 3 years

rate = 12%

So PVIF = 0.71178

Present value of the BPO price = Bargain purchase price to be exercised * PVIF = $12,000 * 0.71178 = $8,541

Now we can calculate the Amount to be recovered by periodic payment. That is by deducting PV of bargain Purchase option from Amount to be recovered.

Amount to be recovered Fair Value	457,779
Less: PV of bargain Purchase option	8,541
Amount to be recovered by periodic payments	449,238

Next step is to calculate PV of annuity. That will be:

Present value Interest factor annuity:

n = 3 years

rate = 12%

PVIFA = 2.69005

Lease payments at the beginning of each of three years: = Amount to be recovered by periodic payments / PVIFA = 449,238 ÷ 2.69005 = $167,000

The lease payment including maintenance cost is calculated as below. This is how Rhone-Metro come up with the $171,000 annual lease payments.

Lease payment of beginning of each year	$167,000
Add: Maintanence Cost	4,000
Lease payment including maintenance costs	$171,000

2. How should this lease be classified (a) by Western Soya Co. (the lessee) and (b) by Rhone-Metro Industries (the lessor)?

Answer:

(a)

Western Soya Co.

Capital lease

(b)

Rhone-Metro Industries

Capital lease: Sales-type lease

Explanation

(a)

Present value of the minimum lease payments equal to or greater than 90% of the fair value of the asset. That is because:

Amount to be recovered by periodic payments	449,238
Add: PV of bargain Purchase option	$8,541
Present value of lease payment	457,779

So here PV of lease payment is equal to fair value of 457,779. So atleast one criteria is met and hence a capital lease.

(b)
The fair value exceeds the lessor’s book value, and hence the equipment is being sold at a profit. So it can be classified as a sales-type lease:

Fair value	457,779
Less: Carrying Value	400,000
Profit	57,779

3. Prepare the appropriate entries for both Western Soya Co. and Rhone-Metro on December 31, 2021.

Answer:

Western Soya Co. (Lessee):

No.	Date	General Journal	Debit	Credit
1	31-Dec-21	Leased equipment	457,779
		Lease payable		457,779
2	31-Dec-21	Lease payable	167,000
		Prepaid maintenance expenses	4,000
		Cash		171,000

Rhone-Metro(Lessor):

No.	Date	General Journal	Debit	Credit
1	31-Dec-21	Lease receivable	457,779
		Cost of goods sold	400,000
		Sales revenue		457,779
		Inventory of equipment		400,000
	31-Dec-21	Cash	171,000
		Maintenance fee payable		4,000
		Lease receivable		167,000

Explanation

Based on the calculations done in the Required 1, we could do the entry for for both Western Soya Co. and Rhone-Metro.

Western Soya Co. (Lessee):

Entry #1 :

Lease equipment= normal sales price = $457,779 (given in question)

Entry #2:

Lease payable = Lease payments at the beginning of each of three years:

= Amount to be recovered by periodic payments / PVIFA = 449,238 ÷ 2.69005 = $167,000

Rhone-Metro(Lessor):

Entry #1 :

Lease equipment= normal sales price = $457,779 (given in question)

Cost of goods sold = equipment cost $400,000 (given in question)

Entry #2:

Lease receivable = 449,238 ÷ 2.69005 = $167,000

4. Prepare an amortization schedule(s) describing the pattern of interest over the lease term for the lessee and the lessor.

Answer:

Lessee and lessor (Bargain purchase option included):

Amortization Schedule

Year	Payments	Effective Interest	Decrease in Balance	Outstanding Balance
2021				457,779
2021	167,000	-	167,000	290,779
2022	167,000	34,894	132,106	158,673
2023	167,000	19,041	147,959	10,714
2024	12,000	1,286	10,714	0
	512,999	55,220	457,779

Calculation

Here, we know that the interest rate is 12%, and the Present value of lease payment is 457,779. So we can calculate the effective interest. For 2021, there is no effective interest. Hence only payment is deducted.

Effective interest = 12% * Outstanding Balance

So 2022 = 290,779 * 12% = 34,894

2023 = 158,673 * 12% = 19,041

2024 = 10,714 * 12% = 1,286

Western Soya Co. exercise a purchase option on December 30, 2024, at an option price of $12,000. So for 2024, the Payment become 12,000.

Decrease in Balance = It is calculated by deducting Effective interest from Payments

5. Prepare the appropriate entries for both Western Soya and Rhone-Metro on December 31, 2022 (the second rent payment and amortization).

Answer:

Western Soya Co. (Lessee):

No.	Date	General Journal	Debit	Credit
1	31-Dec-22	Depreciation expense	76,297
		Accumulated depreciation		76,297
		To record depreciation expense
2	31-Dec-22	Maintenance expense	4,000
		Prepaid maintenance expenses		4,000
		To record operating expense
3	31-Dec-22	Interest expense	34,894
		Lease payable	132,106
		Prepaid maintenance expenses	4,000
		Cash		$171,000
		To record payment of cash

Rhone-Metro(Lessor):

No.	Date	General Journal	Debit	Credit
1	31-Dec-22	Cash	171,000
		Maintenance fee payable		4,000
		Lease receivable		132,106
		Interest revenue		34,894
		To record cash received

Calculation

Western Soya Co. (Lessee):
Entry #1 :

Here we need to calculate the depreciation expense.

Depreciation expense = $457779 ÷ 6 years  = $76,297

Entry #3:
Interest expense = Interest rate * PV of lease payment - lease payment = (12% * ($457779 – 167,000) = $34,894

Lease payable = 167,000 - 34,894 = 132,106

Rhone-Metro(Lessor)

Entry #1 :
Interest revenue = 12% × ($457779 – 167,000) = $34,894

Lease receivable = 167,000 - 34,894 = 132,106

6. Prepare the appropriate entries for both Western Soya and Rhone-Metro on December 30, 2024, assuming the purchase option is exercised on that date.

Answer:

Western Soya Co. (Lessee):

No.	Date	General Journal	Debit	Credit
1	31-Dec-24	Depreciation expense	76,297
		Accumulated depreciation		76,297
		To record amortization expense
2	31-Dec-24	Interest expense	1,286
		Lease payable	10,714
		Cash		12,000
		To record cash payment for bargain purchase option
3	31-Dec-24	Maintenance expense	4,000
		Prepaid maintenance expenses		4,000
		To record maintenance expense
4	31-Dec-24	Prepaid maintenance expenses	4,000
		Cash		4,000
		To record cash payment for maintenance
5	31-Dec-24	Equipment	457,779
		Leased equipment		457,779
		To record transfer of equipment ownership

Rhone-Metro(Lessor):

No.	Date	General Journal	Debit	Credit
1	31-Dec-24	Cash	12,000
		Lease receivable		10,714
		Interest revenue		1,286
		To record cash received for bargain purchase
2	31-Dec-24	Cash	4,000
		Maintenance fee payable		4,000
		To record cash received for maintenance

Calculation

Western Soya Club (Lessee):

Entry #1:

To calculate the depreciation we need to divide the Leased equipment with life of equipment.
Depreciation expense = $457,779 ÷ 6 years = $76,297

Entry #2:

Lease payable = 10,714 : from schedule
Interest expense = 12 % * $10,714 : from schedule = $1,286

Rhone-Metro(Lessor)

Entry #1:

Lease receivable = 10,714 : from schedule
Interest revenue = 12 % * $10,714 : from schedule[rounded]) = $1,286