Question

(Disclosures Required in Various Situations) Ace Inc. produces electronic components for sale to manufacturers of radios, television sets, and digital sound systems. In connection with her examination of Ace’s financial statements for the year ended December 31, 2018, Gloria Rodd, CPA, completed field work 2 weeks ago. Ms. Rodd now is evaluating the significance of the following items prior to preparing her auditor’s report. Except as noted, none of these items have been disclosed in the financial statements or notes.

Item 4: The company’s new manufacturing plant building, which cost \(2,400,000 and has an estimated life of 25 years, is leased from Wichita National Bank at an annual rental of \)600,000. The company is obligated to pay property taxes, insurance, and maintenance. At the conclusion of its 10-year noncancelable lease, the company has the option of purchasing the property for $1. In Ace’s income statement, the rental payment is reported on a separate line.

Instructions

For each of the above items, discuss any additional disclosures in the financial statements and notes that the auditor should recommend to her client. (The cumulative effect of the four items should not be considered.)

Short answer

The lessee must capitalize the leased asset and the related obligation in the balance sheet at the appropriate discounted amount of the future rental payments under the lease agreement.

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.

Additional disclosure in the financial statements

Since the lease agreement with Wichita National Bank includes a discount purchase option (a 25-year life building can be acquired for $1 at the end of ten years), it qualifies as a capital lease. In addition, unless the building's fair value significantly exceeds its $2,400,000 cost, the present value of the lease payment is likely to exceed 90% of the building's fair value.

Consequently, the lessee has to capitalize the leased asset and the corresponding liability in the balance sheet at the discounted amount of future rental payments under the lease agreement. The lessee must disclose the following information in a note:

1. The gross amount of the leased asset and its accumulated depreciation,
2. The minimum future lease payments as on the date of the most recent balance sheet, in aggregate and for each of the next five financial years, plus the number of lease payments the interest charged,
3. A general description of the lease arrangement, and
4. The existence of purchase option terms. A charge for depreciation of the leased asset, as well as an interest charge, must be included in the income statement.