Chapter 15, Problem 15.23P

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 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).

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.

To determine

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. 1. Transfer of title: The asset is transferred to lessee at the end of the lease period concerned.
2. 2. Purchase option: The purchase option is exercisable when the purchase price is sufficiently lower than expected fair value.
3. 3. Economic life: The economic life of the lease period is 75% or more than the useful life of the asset.
4. 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:

$\begin{array}{c}\text{Present value of BPO = Bargain purchase option to be exercised}\times \text{PVIF}\left(10\%,3\right)\\ =\$10,000\times 0.75131\\ =\$7,513\end{array}$ (1)

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:

$\begin{array}{c}\begin{array}{l}Leasepayments\\ atthebeginning\\ ofeachofthenext3years\end{array}\}\text{ = }\left[\frac{\begin{array}{l}Amounttoberecovered\\ byperiodicleasepayments\end{array}}{PVIFA\left(10\%,3\right)}\right]\\ =\frac{\$358,247\left(2\right)}{2.73554}\\ =\$130,960\end{array}$ (3)

To determine

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)

To determine

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:

$\begin{array}{c}\text{Selling profit = Fair Value – Book value}\\ \text{= \$365,760 – \$300,000}\\ \text{=\$65,760}\end{array}$

To determine

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)

To determine

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.

To determine

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

$\begin{array}{c}\text{Amortization expense = }\frac{\text{Present value of lease payments}}{\text{Lease term}}\\ =\frac{\$365,760}{6}\\ =\$60,960\end{array}$ (5)

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.

To determine

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

$\begin{array}{c}\text{Equipment value = Present value of lease payments}-\left(\begin{array}{l}\text{Amortization years}\\ \times \text{ Number of years}\end{array}\right)\\ =\$365,760-\left(\$60,960\times 3\right)\\ =\$365,760-\$182,880\\ =\$182,880\end{array}$ (6)