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, 2016, Rhone-Metro leased equipment to Western Soya Co. for a noncancelable stated lease term of four years ending December 31, 2020, 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, 2020, is not guaranteed. Western Soya Co. can exercise a bargain purchase option on December 30, 2019, at an option price of $10,000. Equal payments under the lease are $134,960 (including $4,000 annual executory costs) and are due on December 31 of each year. The first payment was made on December 31, 2016. Collectibility of the remaining lease payments is reasonably assured, and Rhone-Metro has no material cost uncertainties. 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. Hint: A lease 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 $134,960 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, 2016. (If no entry is required for a transaction/event, select "No journal entry required" in the first account field.) Western Soya Co. (Lessee): Rhone-Metro(Lessor): Rhone-Metro(Lessor): 4. Prepare an amortization schedule(s) describing the pattern of interest over the lease term for the lessee and the lessor. Lessee and lessor (BPO included): 5. Prepare the appropriate entries for both Western Soya and Rhone-Metro on December 31, 2017 (the second rent payment and depreciation). ((If no entry is required for a transaction/event, select "No journal entry required" in the first account field.) Western Soya Co. (Lessee): Rhone-Metro(Lessor): 6. Prepare the appropriate entries for both Western Soya and Rhone-Metro on December 30, 2019, assuming the BPO is exercised on that date. (If no entry is required for a transaction/event, select "No journal entry required" in the first account field.) Western Soya Co. (Lessee): Rhone-Metro(Lessor):

Explanation / Answer

Solution:

1. Show how Rhone-Metro calculated the $134,960 annual lease payments. Unguaranteed Residual Value Table or calculator function: PV of $1 n = 4 i = 10% Present Value Amount to be recovered $365,760 Less: Present value of the unguaranteed residual value -17,075 Amount to be recovered through periodic lease payments $348,685 Lease Payments Table or calculator function: PVAD of $1 n = 4 i = 10% Lease payments at the beginning of each of four years $130,960 Add: Executory costs 4,000 Lease payments including executory costs $134,960 2. How should this lease be classified (a) by Western Soya Co. (the lessee) and (b) by Rhone-Metro Industries (the lessor)? Western Soya Co. Capital lease Rhone-Metro Industries Capital lease: Sales-type lease (b) By Rhone-Metro (the lessor) Since the fair value exceeds the lessor’s carrying value, the equipment is being “sold” at a profit, making this a sales-type lease: Fair value $365,760 Less: Carrying value -300,000 Equals: Dealer’s profit $65,760 3. Prepare the appropriate entries for both Western Soya Co. and Rhone-Metro on December 31, 2016. Western Soya Co. (Lessee) Date General Journal Debit Credit December 31, 2016 Leased equipment $348,685          Lease payable $348,685 December 31, 2016 Lease payable $130,960 Prepaid operating expense 4,000           Cash $134,960 Rhone-Metro (Lessor) Cost of goods sold ($300,000 – [$25,000 × 0.68301]) = $282,925 Sales revenue ($365,760 – [$25,000 × 0.68301]) = $348,685 Date General Journal Debit Credit December 31, 2016 Lease receivable $365,760 Cost of goods sold 282,925        Sales revenue $348,685        Inventory of equipment 300,000 December 31, 2016 Cash $134,960        Executory costs payable 4,000         Lease receivable $130,960 4. Prepare an amortization schedule(s) describing the pattern of interest over the lease term for the lessee and the lessor. Lessee and lessor (BPO included) Lessee (unguaranteed residual value excluded): Lease Amortization Schedule Effective Interest Date Cash Payment 10% × Outstanding Balance Decrease in Balance Outstanding Balance 'December 31, 2016 $348,685 2016 $130,960 0 $130,960 $217,725 2017 $130,960 0.10 (217,725) = $21,773 $109,187 $108,538 2018 $130,960 0.10 (108,538) = $10,834 $98,353 $10,185 2019 $130,960 0.10 (10,185) = $1,019 $10,185 $0.00 $523,840 $33,626 $348,685 Lessor (unguaranteed residual value included): Lease Amortization Schedule Effective Interest Date Cash Payment 10% × Outstanding Balance Decrease in Balance Outstanding Balance 'December 31, 2016 $365,760 2016 $130,960 0 $130,960 $234,800 2017 $130,960 0.10 (234,800) = $23,480 $107,480 $127,320 2018 $130,960 0.10 (127,320) = $12,732 $94,748 $32,572 2019 $130,960 0.10 (32,572) = $3,257 $91,491 ($58,919) 2020 $25,000 0.10 (58,919) = ($5,892) ($58,919) $0 $548,840 $33,577 $365,760 5. Prepare the appropriate entries for both Western Soya and Rhone-Metro on December 31, 2017 Western Soya Co. (Lessee) Depreciation expense ([$348,685] ÷ 4 years) = $87,171 Interest expense (10% × [$348,685 – 130,960]) = $21,773 Rhone-Metro(Lessor) Interest revenue (10% × [$365,760 – 130,960]) = $23,480 Western Soya Co. (Lessee) Date General Journal Debit Credit December 31, 2017 Depreciation expense 87,171 Accumulated depreciation 87,171 December 31, 2017 Operating expense 4,000 Prepaid operating expense 4,000 December 31, 2017 Interest expense 21,773 Lease payable 109,187 Prepaid operating expense 4,000 Cash 134,960 December 31, 2017 Cash 134,960 Executory costs payable 4,000 Lease receivable 107,480 Interest revenue 23,480 6. Prepare the appropriate entries for both Western Soya and Rhone-Metro on December 30, 2019 Western Soya Club (Lessee) Depreciation expense ([$348,685] ÷ 4 years) = $87,171 Rhone-Metro(Lessor) Loss on leased assets ($25,000 – 1,500) = $23,500 Interest revenue (10% × 32,572: from schedule) = $3,257 Western Soya Co. (Lessee) Date General Journal Debit Credit December 31, 2019 Operating expense 4,000 Prepaid operating expense 4,000 December 31, 2019 Depreciation expense 87,171 Accumulated depreciation 87,171 December 31, 2019 Accumulated depreciation 348,685 Leased equipment 348,685 Rhone-Metro (Lessor) Rhone-Metro (Lessor) Date General Journal Debit Credit December 31, 2019 Inventory of equipment 1,500 Loss on leased assets 23,500 Lease receivable 32572 Interest revenue 7,572

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