Rhone-Metro Industries manufactures equipment that is sold or leased. On Decembe

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 $450,000 to manufacture and has an expected useful life of six years. Its normal sales price is $494,424. The expected residual value of $40,000 at December 31, 2022, is not guaranteed. Equal payments under the lease are $134,000 (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 10%. Western Soya knows the interest rate implicit in the lease payments is 8%. 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 $134,000 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 $1,000

Explanation / Answer

1. calculation of lease payments

amount to be recovered (fair value) ----------------------------------------------------------------- $494424

less-present value of the guaranteed residencial value ($40000*0.73500*) ------------------ ($29400)

Amount to be recovered through periodic lease payment= -------------------------------------------- $465024

Lease payment at the beginning of each of 4years (465024/3.57710**)--------------------------- $130000

*present value of $1; n=4 and i=8%

**present value of an annuity due of $1; n=4 and i=8%

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 for lessor, it is 100% ($494424 ÷ $494424); Yes for lessee, it is 95% ($465024 ÷ $494424)

Additional Lessor Criteria

1. Collectibility of the minimum lease payments is reasonably assured? Yes

2. Any lessor costs yet to be incurred are reasonably predictible? Yes

Therefore: Capital lease for lessee because it meets the 4th criterion. Sales-type 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 sales-type because cost and fair market value are not equal.

3.Prepare the appropriate entries for both Western Soya Co., and RhoneMetro on December 31, 2018

Western Soya Co. (Lessee)

Leased asset ---------------------------------------------------------------------------------- 465024

Lease payable -------------------------------------------------------------------------------- 465024

Lease payable---------------------------------------------------------------------------------- 130000

Prepaid lease expense----------------------------------------------------------------------- 4,000

Cash -------------------------------------------------------------------------------------------- 1340000(130000+4000)

Rhone-Metro (Lessor)

Lease receivable --------------------------------------------------------------------- 494424

Cost of goods sold ($450000 – 29400)------------------------------------------------- 420600

Sales (494424 – 29400)------------------------------------------------------------ 465024

Equipment --------------------------------------------------------------------------- 450000

Cash ------------------------------------------------------------------------------------- 1340000(130000+4000)

Executory cost payable -------------------------------------------------------- 4,000

Lease receivable ------------------------------------------------------------------- 130,000

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