Operating Lease vs. Capital Lease
Response to the following problem:
You are auditing the December 31, 2014, 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, 2014, 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. Rental of $3,240 per year (at the end of each year). (The present value at 8% per year is $10,731.)
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. Estimated economic life of the automobile is 5 years.
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.)