Problem - Guaranteed residual value; direct financing lease

On December 31, 2011, Rhone-Metro Industries 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 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, 2015, 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, 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 $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, 2011.

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, 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.

Problem - Sales-type lease; bargain purchase option exercisable before lease term ends; lessor and lessee

Mid-South Auto Leasing leases vehicles to consumers. The attraction to customers is that the company can offer competitive prices due to volume buying and requires an interest rate implicit in the lease that is one percent below alternate methods of financing. On September 30, 2011, the company leased a delivery truck to a local florist, Anything Grows.

The lease agreement specified quarterly payments of $3,000 beginning September 30, 2011, the inception of the lease, and each quarter (December 31, March 31, and June 30) through June 30, 2014 (three-year lease term). The florist had the option to purchase the truck on September 29, 2013, for $6,000 when it was expected to have a residual value of $10,000. The estimated useful life of the truck is four years. Mid-South Auto Leasing's quarterly interest rate for determining payments was 3% (approximately 12% annually). Mid-South paid $25,000 for the truck. Both companies use straight-line depreciation. Anything Grows' incremental interest rate is 12%.

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. Calculate the amount of dealer's profit that Mid-South would recognize in this sales-type lease. (Be careful to note that, although payments occur on the last calendar day of each quarter, since the first payment was at the inception of the lease, payments represent an annuity due.)

2. Prepare the appropriate entries for Anything Grows and Mid-South on September 30, 2011.

3. Prepare an amortization schedule(s) describing the pattern of interest expense for Anything Grows and interest revenue for Mid-South Auto Leasing over the lease term.

4. Prepare the appropriate entries for Anything Grows and Mid-South Auto Leasing on December 31, 2011.

5. Prepare the appropriate entries for Anything Grows and Mid-South on September 29, 2013, assuming the bargain purchase option was exercised on that date.