Task: (Operating Lease vs. Capital Lease)
You are auditing the December 31, 2006, financial statements of Sarah Shamess, Inc., manufacturer of novelties and party favors. During your inspection of the company garage, you discovered that a 2005 Shirk automobile not listed in the equipment subsidiary ledger is parked in the company garage. You ask Sally Straub, 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, 2006, with Jack Hayes 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. Rental of $2,160 per year (at the end of each year). (The present value at 8% per year is $7,154.)
3. Estimated residual value after 4 years is $1,100. (The present value at 8% per year is $809.) Shamess guarantees the residual value of $1,100.
4. Estimated economic life of the automobile is 5 years.
5. Shamess'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.)