Concept explainers
Guaranteed residual value; sales-type lease
• LO15–2, LO15–5, LO15–6
(Note: Problems 21, 22, and 23 are three variations of the same basic situation.)
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 $365,760 and has an expected useful life of six years. Its normal sales price is $365,760. The lessee-guaranteed residual value at December 31, 2022, is $25,000. Equal payments under the lease are $100,000 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 12%. Western Soya knows the interest rate implicit in the lease payments is 10%. Both companies use straight-line
Required:
- 1. Show how Rhone-Metro calculated the $100,000 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)? Why?
- 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 $1,500.
(1)
The criteria for defining the lease as finance lease or operating lease
As per the notes issued by Financial Accounting Standard Board (FASB), the following are four criteria to determine is a lease is a capital lease or an operating lease:
- 1. Transfer of title: The asset is transferred to lessee at the end of the lease period concerned.
- 2. Purchase option: The purchase option is exercisable when the purchase price is sufficiently lower than expected fair value.
- 3. Economic life: The economic life of the lease period is 75% or more than the useful life of the asset.
- 4. Value recovery: Present value of lease payments is greater or equal to 90% of the fair value.
If a particular lease fulfils any one of the above four criteria, then it is considered as finance lease. If a lease does not fulfil any of the above four criteria, it would be considered as operating lease.
Sales-type lease
Sales type is a parallel type of direct financing whereby the owner (lessor) purchases the equipment to lease it and received the interest revenue over the period of lease for equipment, apart from the recognition of profit from sale of equipment.
Lessee guaranteed residual value
The lessee guaranteed residual value of leased asset is an estimation of the commercial value of the asset at the end of lease term. The present value is considered when determining the lease classification criteria (Criteria 4). Lessee guaranteed residual value is added to lease receivable and also added to sales revenue.
To Show: how RM Industries (Lessor) calculated the $1000,000 annual lease payments.
Explanation of Solution
Calculate lease payments at the beginning of each of the next 4 years:
Working note:
Calculate the present value of exercise price
Calculate the amount to be recovered through periodic lease
Amount ($) | |
Amount to be recovered (Fair value of asset) | 365,760 |
Less: Present value of exercise price (1) | 17,075 |
Amount to be recovered by periodic lease payments | 348,685 |
(2)
Hence, the lease payments at the beginning each of four years is $100,000.
(2)(a)
the appropriate classification of lease by lessee and state the reason.
Explanation of Solution
Since at least one criteria is met, the lease is a finance lease to the lessee. The Lessee records the present value of lease payments as lease payable and right-of-use asset.
Working note:
The present value of lease payments is calculated as below:
The classification criteria for lessor are as follows:
S.No | Classification criteria | Does it satisfy? | |
1 | Does the lease agreement specify about ownership transfer? | No | |
2 | Does the lease agreement state about bargain purchase option? | No | |
3 | Does the term of lease constitute major part of the expected economic life of the asset? | No | Lease term = 4 years Useful life = 6 years |
4 | Is the present value of lease payments greater than or equal to substantially all of the market/fair value of the asset? | Yes | Present value (3) = $365,760 Fair value = $365,760 |
5 | Is the asset is of such a specialized nature which is expected to have an alternative use to lessor at the end of the term of lease? | No |
Table (1)
(2)(b)
the appropriate classification of lease by lessor and state the reason.
Explanation of Solution
Since at least one criteria is met, the lease is a sales type lease to the lessor.
The classification criteria for lessor are as follows:
S.No | Classification criteria | Does it satisfy? | |
1 | Does the lease agreement specify about ownership transfer? | No | |
2 | Does the lease agreement state about bargain purchase option? | No | |
3 | Does the term of lease constitute major part of the expected economic life of the asset? | No | Lease term = 4 years Useful life = 6 years |
4 | Is the present value of lease payments greater than or equal to substantially all of the market/fair value of the asset? | Yes | Present value (3) = $365,760 Fair value = $365,760 |
5 | Is the asset is of such a specialized nature which is expected to have an alternative use to lessor at the end of the term of lease? | No |
Table (2)
(3)
To Prepare: appropriate entries for WS Company (Lessee) and RM industries (Lessor)
Explanation of Solution
Prepare journal entries for WS Company (Lessee) on December 31, 2018
Date | Accounts title and explanation | Post Ref. | Debit ($) |
Credit ($) |
|
Right-of-use asset (4) | 348,685 | ||||
Lease Payable | 348,685 | ||||
(To record the lease payable) | |||||
Lease payable | 100,000 | ||||
Cash | 100,000 | ||||
(To record annual lease payment.) |
Table (3)
Working note:
Use the present value of an ordinary annuity factor (3.48685) (Present value of $1 for 4 periods at 10% rate).
The present value of lease payments that would be recorded as right-of-use asset is calculated as below:
Prepare journal entries for RM Company (Lessor) on December 31, 2018
Date | Account Title and Explanation | Post Ref | Debit ($) | Credit ($) | |
Lease Receivable (3) | 365,760 | ||||
Equipment | 365,760 | ||||
(To record the lease receivable) | |||||
Cash | 100,000 | ||||
Lease receivable | 100,000 | ||||
(To record the lease payments received) |
Table (4)
(4)
To Prepare: amortization schedule for WS Company (Lessee) and RM Company (Lessor)
Explanation of Solution
The present value of periodic lease payments and present value of unguaranteed residual value combine to help the lessor in recovering its investment and are recorded as lease receivable.
Prepare amortization schedule for lessor as follows:
Lease Amortization Schedule | ||||
A | B | C | D | E |
Date (December 31) | Lease Payment ($) | Effective Interest (10% × Outstanding balance) ($) | Payment Reduction ($) (B –C) |
Outstanding Balance ($) (E –D) |
2018 | 365,760 | |||
2018 | 100,000 | 100,000 | 265,760 | |
2019 | 100,000 | 26,576 | 73,424 | 192,336 |
2020 | 100,000 | 19,234 | 80,766 | 111,570 |
2021 | 100,000 | 11,157 | 88,843 | 22,727 |
2022 | 25,000 | 2,273 | 22,727 | 0 |
425,000 | 59,240 | 365,760 |
Table (5)
The lessee takes the residual value as a lease payment only if the payment of cash is estimated due to the lessee-guaranteed residual value. But in this case, this is not present.
Prepare amortization schedule for lessee as follows:
Lease Amortization Schedule | ||||
A | B | C | D | E |
Date (December 31) | Lease Payment ($) | Effective Interest (10% × Outstanding balance) ($) | Payment Reduction ($) (B –C) |
Outstanding Balance ($) (E –D) |
2018 | 348,685 | |||
2018 | 100,000 | 100,000 | 248,685 | |
2019 | 100,000 | 24,869 | 75,132 | 173,554 |
2020 | 100,000 | 17,355 | 82,645 | 90,909 |
2021 | 100,000 | 9,091 | 90,909 | 0 |
400,000 | 51,315 | 348,685 |
Table (6)
The amortization table is prepared to present the pattern of interest expenses throughout the period. The schedule shows the lease balance and effective interest change over the 8-quarterly term period of lease using effective interest rate of 3%. Each lease payment after the first payment includes both the interest and amount that represents the reduction of outstanding balance. At the end of the lease period, the outstanding balance becomes zero.
(5)
To Prepare: appropriate entries for WS Company (Lessee) and RM Company (Lessor) as on December 31, 2019.
Explanation of Solution
Prepare journal entries for WS Company (Lessee) on December 31, 2019
Date | Account Title and Explanation | Post Ref | Debit ($) | Credit ($) |
Amortization expense (5) | 87,171 | |||
Right-of-use asset | 87,171 | |||
(To record amortization expense.) | ||||
Interest expense Table (6) | 24,869 | |||
Lease payable (Difference) | 75,131 | |||
Cash | 100,000 | |||
(To record the lease payments and interest expense) |
Table (7)
Working note:
Calculate the amortization expense for the asset
Prepare journal entries for RM Company (Lessor) on December 31, 2019
Date | Account Title and Explanation | Post Ref | Debit ($) | Credit ($) |
Cash | 100,000 | |||
Lease receivable (Difference) | 73,424 | |||
Interest revenue Table (5) | 26,576 | |||
(To record interest revenue.) |
Table (8)
(6)
To Prepare: appropriate entries for WS Company (Lessee) and RM Company (Lessor) as on December 31, 2022 assuming the equipment is returned to lessor.
Explanation of Solution
(Given)
The equipment is returned is lessor and actual residual value is $1,500.
Prepare journal entries for WS Company (Lessee) on December 31, 2022
Date | Account Title and Explanation | Post Ref | Debit ($) | Credit ($) |
Amortization expense (5) | 87,171 | |||
Right-of-use asset | 87,171 | |||
(To record amortization expense.) | ||||
Loss on residual value guarantee | 23,500 | |||
Cash (6) | 23,500 | |||
(To record the loss on residual value guarantee) |
Table (9)
Working note:
Calculate the loss on residual value guarantee
Prepare journal entries for RM Company (Lessor) on December 31, 2022
Date | Account Title and Explanation | Post Ref | Debit ($) | Credit ($) |
Cash (6) | 23,500 | |||
Equipment | 1,500 | |||
Lease receivable | 22,727 | |||
Interest revenue Table (5) | 2,273 | |||
(To record interest revenue.) |
Table (10)
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