Question: You are auditing the December 31, 2019 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 subledger 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 and elected to use the short-term lease accounting option for the lease. The lease agreement was entered into on January 1, 2019 with Crown New and Used Cars.
You decide to review the lease agreement to ensure that the lease should be afforded short-term lease treatment and you discover the following lease terms:
1. Non-cancelable term of 2 years.
2. Rent of $3,240 per year. The present value of the lease payments using Hockney's incremental borrowing rate of 8% is $6,240.
3. Expected residual value after 2 years is $500 (present value is $429). Hockney guarantees the residual value of $500, which is equal to the expected residual value.
4. Estimated economic life of the automobile is 2.5 years.
Instructions: Write an email to Alex Barnes, the audit partner in charge of the Hockney audit, to discuss the above situation. Be sure to include (a) how you identified the issue, (b) what you determined about the accounting treatment of the lease, and (c) propose any journal entries necessary to correct the financial statements.
Try to limit your response to one page.
Hint: When proposing journal entries, consider what JEs need to be recorded that have not been recorded. Also, consider any JEs that were incorrectly recorded that will need to be reversed.