Question

(Operating Lease vs. Capital Lease) You are auditing the December 31, 2017, financial statements of Hockney, Inc., manufacturer of novelties and party favors. During your inspection of the company garage, you discovered that a used automobile not listed in the equipment subsidiary ledger is parked there. You ask Stacy Reeder, plant manager, about the vehicle, and she tells you that the company did not list the automobile because the company was only leasing it. The lease agreement was entered into on January 1, 2017, with Crown New and Used Cars.

You decide to review the lease agreement to ensure that the lease should be afforded operating lease treatment, and you discover the following lease terms.

1. Noncancelable term of 4 years.
2. 2. Rental of \(3,240 per year (at the end of each year). (The present value at 8% per year is \)10,731.)
3. 3. Estimated residual value after 4 years is \(1,100. (The present value at 8% per year is \)809.) Hockney guarantees the residual value of $1,100.
4. 4. Estimated economic life of the automobile is 5 years.
5. 5. Hockney’s incremental borrowing rate is 8% per year.

Instructions

You are a senior auditor writing a memo to your supervisor, the audit partner in charge of this audit, to discuss the above situation. Be sure to include (a) why you inspected the lease agreement, (b) what you determined about the lease, and (c) how you advised your client to account for this lease. Explain every journal entry that you believe is necessary to record this lease properly on the client’s books. (It is also necessary to include the fact that you communicated this information to your client.)

Short answer

The following entry should be passed for

Lease liability is $11,540

Interest expense is $923

Accumulated depreciation is $2,610

Step-by-step solution

Meaning of Audit report

Financial statements contain a statement called an audit report. In financial accounts, this includes the auditor's opinion. The auditor is accountable to the board of directors and the shareholders who elect them. He is required to express his views on the accuracy and fairness of the financial statements.

Explaining the situation in a report

Memorandum Prepared by

Date:

HOCKNEY, INC.

December 31, 2017

Reclassification of Leased Auto

As a Capital Lease

During a scheduled review of a client's garage, I noticed a used car that was not recorded as one of the company's resources within the Appliance Assistant Ledger. When I asked about the vehicle with Plant Director Stacy Reeder, she replied that it was not included in other commerce resources because it was under a proper lease. After accounting for this agreement as an operating lease, Hockney, Inc. charged $3,240 in 2017 rent charges.

I concluded that the automobile should be capitalized after reviewing the non-cancelable lease agreement signed with Crown New and Used Cars on January 1, 2017. The lease period (4 years) is longer than 75% of the vehicle's useful life (5 years).

I suggested the customer capitalize this lease at the present value of the minimum lease payments: $10,731 (the present value of the monthly payments), plus $809 (the present value of the interest payments) (the present value of the guaranteed residual). It was advised that you write the following entry in your journal:

Date	Particular	Debit ($)	Credit ($)
	Leased Equipment	11,540
	Lease Liability		11,540

To account for the first year’s payments as well as to reverse the original entries, I advised the client to make the following entry:

Date	Particular	Debit ($)	Credit ($)
	Lease Liability	2,317
	Interest Expense	923
	Rent Expense		3,240

Finally, during the course of the lease, this car must be depreciated. I calculated annual depreciation of $2,610 using a straight line (capitalized amount of $11,540 minus guaranteed residual of $1,100 divided by 4 year lease period). To record 2017 depreciation, the customer was recommended to make the following entry:

Date	Particular	Debit ($)	Credit ($)
	Depreciation Expense	2,610
	Accumulated Depreciation Capital Leases		2,610