Problem 15-23 Purchase option reasonably certain to be exercised before lease term ends; nonlease payments; sales-type lease [LO15-3, 15-6, 15-7]

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 Soyas 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 its expected to be exercised (i.e., a BPO). (FV of $1, PV of $1, FVA of $1, PVA of $1, FVAD of $1 and PVAD of $1) (Use appropriate factor(s) from the tables provided.)

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)? 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.