On December 31, 2018, Rhone-Metro Industries leased equipment to Western Soya Co

Question

On December 31, 2018, Rhone-Metro Industries 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 Rhone-Metro $347,516 and has an expected useful life of six years. Its normal sales price is $347,516. The lessee-guaranteed residual value at December 31, 2022, is $17,000. Equal payments under the lease are $95,000 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 10%. Western Soya knows the interest rate implicit in the lease payments is 9%. 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 $95,000 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 all appropriate entries for both Western Soya and Rhone-Metro on December 31, 2019 (the second lease payment and depreciation).
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 $2,000.

Explanation / Answer

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Since Lessee borrowing rate 10% is higher than Lessor implicate rate of 9% which is known to Lessee, all calculation will be at 9%

1. Show how Rhone-Metro calculated the $95,000 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)?

Since PV of Lease payment is equal to fair value (347516), this is Capital Lease for Lessee.

Also, lease payment are reasonably assured, and cost is equal to sale price, this is direct financing lease for 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 all appropriate entries for both Western Soya and Rhone-Metro on December 31, 2019 (the second lease payment and depreciation).

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 $2,000.

Fair Value/Sale Value 347516 Less:Present Value of Guranteed Salvage 17000*0.7084 (PV 9%, 4 Year) 12043 Total 335473 Divided by PVAF 9%, 4 Year 335473/3.531295 95000 Annual Lease Payment 95000

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