Reference no: EM13140903

Unguaranteed residual value; executory costs; sales-type lease LO6 LO8 LO9

Rhone-Metro Industries manufactures equipment that is sold or leased. On December 31, 2011, Rhone-Metro leased equipment to Western Soya Co. for a four-year period ending December 31, 2015, 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, 2015, is not guaranteed. Equal payments under the lease are $104,000 (including $4,000 executory costs) and are due on December 31 of each year. The first payment was made on December 31, 2011. 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.

Required:

1. Show how Rhone-Metro calculated the $104,000 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, 2011.

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, 2012 (the second lease payment and depreciation).

6. Prepare the appropriate entries for both Western Soya and Rhone-Metro on December 31, 2015, assuming the equipment is returned to Rhone-Metro and the actual residual value on that date is $1,500.