Concept explainers
Purchase option reasonably certain to be exercised before lease term ends; nonlease payments; sales-type lease
• LO15–3, LO15–6, LO15–7
Rhone-Metro Industries manufactures equipment that is sold or leased. On December 31, 2018, Rhone-Metro leased equipment to Western Soya Co. for a noncancelable stated lease term of four years ending December 31, 2022, 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, 2022, is not guaranteed. Western Soya Co. is reasonably certain to exercise a purchase option on December 30, 2021, at an option price of $10,000. Equal payments under the lease are $134,960 (including $4,000 annual 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 12%. Western Soya knows the interest rate implicit in the lease payments is 10%. Both companies use straight-line
Hint: A lease term ends for accounting purposes when an option becomes exercisable if it’s expected to be exercised (i.e., a BPO).
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)? 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 the appropriate entries for both Western Soya and Rhone-Metro on December 31, 2019 (the second rent payment and depreciation).
6. Prepare the appropriate entries for both Western Soya and Rhone-Metro on December 30, 2021, assuming the purchase option is exercised on that date.
(1)
Lease
Lease is a contractual agreement whereby the right to use an asset for a particular period of time is provided by the owner of the asset to the user of the asset. The owner, who possesses the asset, is termed as ‘Lessor’ and user, to whom the right is transferred to, is termed as ‘Lessee’.
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.
Purchase option
Purchase option is provision of certain lease contracts which provides the lessee the option to purchase the leased asset during the period of lease or at the end of the lease term at a particular exercise price.
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.
To Show: how the annual lease payments of $134,960 is being calculated.
Explanation of Solution
Amount ($) | |
Lease payments at the beginning of each of the next 3 years (3) | 130,960 |
Add: Maintenance cost | 4,000 |
Lease payments including maintenance costs | 134,960 |
Table (1)
Working notes:
Calculate present value of BPO:
Calculate the amount to be recovered by periodic lease payments:
Amount ($) | |
Amount to be recovered (Fair value) | 365,760 |
Less: Present value of bargain purchase option (1) | 7,513 |
Amount to be recovered by periodic lease payments | 358,247 |
(2)
Calculate lease payments at the beginning of each of the next 3 years:
(2) (a)
the appropriate classification of lease by lessee and state the reason.
Explanation of Solution
Since at least one criteria is met, the lease is a finance lease to the lessee. The Lessee records the present value of lease payments as lease payable and right-of-use asset.
Working note:
The present value of lease payments is calculated as below:
Amount ($) | |
Amount to be recovered by periodic lease payments (2) | 358,247 |
Add: Present value of bargain purchase option (1) | 7,513 |
Present value of lease payments | 365,760 |
(4)
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 = 3 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 (4) = $365,760 Fair value = $365,760 |
5 | Is the asset being of such a specialized nature which is expected to have an alternative use to lessor at the end of the term of lease? | No |
Table (2)
(2) (b)
the appropriate classification of lease by lessor and state the reason.
Explanation of Solution
Since at least one criteria is met, the lease is a sales type lease with a selling profit to the lessor. The selling profit is calculated as follows:
(3)
To Prepare: appropriatejournal entries for WS Company (Lessee) and Company RM (Lessor) on December 31, 2018.
Explanation of Solution
Prepare journal entry for WS Company (Lessee) in the month of December 31, 2018
Date | Accounts title and explanation | Post Ref. | Debit ($) |
Credit ($) |
|
Right-of-use asset (4) | 365,760 | ||||
Lease Payable | 365,760 | ||||
(To record the lease payable) |
Table (3)
Transaction on December 31, 2018: Record the lease payments and prepaid maintenance expense.
Date | Account Title and Explanation | Post Ref | Debit ($) | Credit ($) |
Prepaid maintenance expenses | 4,000 | |||
Lease payable (Difference) | 130,960 | |||
Cash | 134,960 | |||
(To record annual lease payment and maintenance expenses.) |
Table (4)
Prepare journal entry for RM Company (Lessor) in the month of December 31, 2018
Date | Account Titles and Explanation | Post Ref. | Debit ($) | Credit ($) | |
Lease Receivable | 365,760 | ||||
Cost of Goods Sold (Lessor’s cost) | 300,000 | ||||
Sales Revenue (4) | 365,760 | ||||
Equipment | 300,000 | ||||
(To record lease inception) |
Table (5)
Journalize the lease receivable: December 31, 2018
Date | Accounts Title and Explanation | Post Ref. | Debit ($) |
Credit ($) |
|
Cash | 134,960 | ||||
Lease Receivable | 130,960 | ||||
Maintenance fee payable | 4,000 | ||||
(To record the lease received) |
Table (6)
(4)
To Prepare: an amortization schedule describing the pattern of interest over the lease term for the lessee and lessor.
Explanation of Solution
Prepare amortization schedule for lessor and lessee as follows: (Bargain purchase option included)
Lease Amortization Schedule | ||||
A | B | C | D | E |
Date (December 31) | Lease Payment ($) | Effective Interest (10% × Outstanding balance) ($) | Payment Reduction ($) (B –C) |
Outstanding Balance ($) (E –D) |
2018 | 365,760 | |||
2018 | 130,960 | 130,960 | 234,800 | |
2019 | 130,960 | 23,480 | 107,480 | 127,320 |
2020 | 130,960 | 12,732 | 118,228 | 9,092 |
2021 | 10,000 | 908 | 9,092 | 0 |
402,880 | 37,120 | 365,760 |
Table (7)
Here the lessor and lessee use the same discount rate and also the bargain purchase option is included in additional payment for both the lessor and lessee. Therefore, the same amortization schedule applies for both lessee and lessor.
(5)
To Prepare: appropriate entries for both WS Company (Lessee) and Company RM (Lessor) on December 31, 2019.
Explanation of Solution
Prepare journal entries for WS Company (Lessee) on December 31, 2019
Date | Account Title and Explanation | Post Ref | Debit ($) | Credit ($) |
Amortization expense (5) | 60,960 | |||
Right-of-use asset | 60,960 | |||
(To record amortization expense.) | ||||
Maintenance expense | 4,000 | |||
Prepaid Maintenance expense | 4,000 | |||
(To record expensing of prepaid maintenance expense.) | ||||
Interest expense Table (7) | 23,480 | |||
Lease payable (Difference) | 107,480 | |||
Prepaid maintenance expense | 4,000 | |||
Cash | 134,960 | |||
(To record the lease payments and interest expense) |
Table (8)
Working note:
Calculate the amortization expense for the asset
Prepare journal entries for RM Company (Lessor) on December 31, 2019
Date | Account Title and Explanation | Post Ref | Debit ($) | Credit ($) |
Cash | 134,960 | |||
Maintenance fee payable | 4,000 | |||
Lease receivable (Difference) | 107,480 | |||
Interest revenue Table (7) | 23,480 | |||
(To record interest revenue.) |
Table (9)
Here the ownership transfers by contract or by expected exercise of bargain purchase option (BPO), asset must be depreciated over the asset’s useful life. In this case the equipment is expected to be useful for 6 years term.
(6)
To Prepare: appropriate entries for WS Company (Lessee) and RM Company (Lessor) as on December 31, 2021 assuming the purchase option is exercise on that date.
Explanation of Solution
Prepare journal entries for WS Company (Lessee) on December 31, 2021
Date | Account Title and Explanation | Post Ref | Debit ($) | Credit ($) |
Amortization expense (5) | 60,960 | |||
Right-of-use asset | 60,960 | |||
(To record amortization expense.) | ||||
Maintenance expense | 4,000 | |||
Prepaid Maintenance expense | 4,000 | |||
(To record expensing of prepaid maintenance expense for 2019.) | ||||
Prepaid Maintenance expense | 4,000 | |||
Cash | 4,000 | |||
(To record payment of prepaid maintenance expense for 2022.) | ||||
Interest expense Table (7) | 908 | |||
Lease payable (Difference) | 9,092 | |||
Cash | 10,000 | |||
(To record the lease payments and interest expense) | ||||
Equipment (6) | 182,880 | |||
Right-of-use asset | 182,880 | |||
(To record exercise of purchase option.) |
Table (10)
Prepare journal entries for RM Company (Lessor) on December 31, 2021
Date | Account Title and Explanation | Post Ref | Debit ($) | Credit ($) |
Cash (Bargain purchase option price) | 10,000 | |||
Lease receivable | 9,092 | |||
Interest revenue Table (7) | 908 | |||
(To record interest revenue.) | ||||
Cash | 4,000 | |||
Maintenance fee payable | 4,000 | |||
(To record maintenance fee payable.) |
Table (11)
Working note:
Calculate the equipment value after 3 years
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Chapter 15 Solutions
CONNECT INTERMED.ACCTG (CONNECT+ALEKS)
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