Chapter 15, Problem 15.21P

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 depreciation.

Required:

1. 1. Show how Rhone-Metro calculated the $100,000 annual lease payments.
2. 2. How should this lease be classified (a) by Western Soya Co. (the lessee) and (b) by Rhone-Metro Industries (the lessor)? Why?
3. 3. Prepare the appropriate entries for both Western Soya Co. and Rhone-Metro on December 31, 2018.
4. 4. Prepare an amortization schedule(s) describing the pattern of interest over the lease term for the lessee and the lessor.
5. 5. Prepare all appropriate entries for both Western Soya and Rhone-Metro on December 31, 2019 (the second lease payment and depreciation).
6. 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.

To determine

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.

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:

$\begin{array}{c}\begin{array}{l}Leasepayments\\ atthebeginning\\ ofeachofthenext4years\end{array}\}\text{ = }\left[\frac{\begin{array}{l}Amounttoberecovered\\ byperiodicleasepayments\end{array}}{PVIFA\left(10\%,4\right)}\right]\\ =\frac{\$348,685\left(2\right)}{3.48685}\\ =\$100,000\end{array}$

Working note:

Calculate the present value of exercise price

$\begin{array}{c}\text{Present value of exercise price = Exercise price}\times \text{PVIF}\left(10\%,4\right)\\ =\$25,000\times 0.68301\\ =\$17,075\end{array}$ (1)

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)

Conclusion

Hence, the lease payments at the beginning each of four years is $100,000.

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:

$\begin{array}{c}\begin{array}{l}\text{Present value of }\\ \text{lease payments}\end{array}\}\text{ =}\left[\begin{array}{l}\text{Present value of periodic }\\ \text{lease payments + Present value of }\\ \text{lessee guranteed residual value}\end{array}\right]\\ =\left[\begin{array}{c}\left(\begin{array}{l}\text{Annual lease }\\ \text{payments}\times \text{PVIFA }\left(\text{10\%,4yrs}\right)\end{array}\right)\\ +\left(\begin{array}{l}\text{Guaranteed residual value}\\ \times \text{PVIF }\left(\text{10\%,4yrs}\right)\end{array}\right)\end{array}\right]\\ =\left(\$100,000\times 3.48685\right)+\left(\$25,000\times 0.68301\right)\\ =\$365,760\end{array}$ (3)

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)

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 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)

To determine

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:

$\begin{array}{c}\begin{array}{l}\text{Present value of }\\ \text{periodic lease payments}\end{array}\}\text{ =}\left[\text{Annual lease payments}\right]\times \text{PVIFA }\left(\text{10\%,4yrs}\right)\\ =\$100,000\times 3.48685\\ =\$348,685\end{array}$ (4)

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)

To determine

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.

To determine

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

$\begin{array}{c}\text{Amortization expense = }\frac{\text{Present value of lease payments}}{\text{Lease term}}\\ =\frac{\$348,685}{4}\\ =\$87,171\end{array}$ (5)

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)

To determine

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

$\begin{array}{c}\text{Loss on residual value guarantee = }\left[\begin{array}{l}\text{Lessee guaranteed }\\ \text{residual value}-\text{Actual residual value}\end{array}\right]\\ =\$25,000-\$1,500\\ =\$23,500\end{array}$ (6)

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)