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Chapter 21: Q15P. (page 1250)

(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鈥檚 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鈥檚 books. (It is also necessary to include the fact that you communicated this information to your client.)

Short Answer

Expert verified

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

01

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.

02

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鈥檚 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

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Most popular questions from this chapter

Question: (Lessee Entries and Balance Sheet Presentation, Capital Lease) On January 1, 2017, Cage Company contracts to lease equipment for 5 years, agreeing to make a payment of \(137,899 (including the executory costs of \)6,000) at the beginning of each year, starting January 1, 2017. The taxes, the insurance, and the maintenance, estimated at \(6,000 a year, are the obligations of the lessee. The leased equipment is to be capitalized at \)550,000. The asset is to be depreciated on a double-declining-balance basis, and the obligation is to be reduced on an effective-interest basis. Cage鈥檚 incremental borrowing rate is 12%, and the implicit rate in the lease is 10%, which is known by Cage. Title to the equipment transfers to Cage when the lease expires. The asset has an estimated useful life of 5 years and no residual value.

Instructions

(f) What amounts will appear on the lessee鈥檚 December 31, 2017, balance sheet relative to the lease contract?

Waterworld Company leased equipment from Costner Company. The lease term is 4 years and requires equal rental payments of \(43,019 at the beginning of each year. The equipment has a fair value at the inception of the lease of \)150,000, an estimated useful life of 4 years, and no salvage value. Waterworld pays all executory costs directly to third parties. The appropriate interest rate is 10%. Prepare Waterworld鈥檚 January 1, 2017, journal entries at the inception of the lease.

A lease agreement between Mooney Leasing Company and Rode Company is described in E21-8.

Inception date

May 1, 2017

Annual lease payment due at the beginning

of each year, beginning with May 1, 2017

\(21,227.65

Bargain-purchase option price at end of lease term

\) 4,000.00

Lease term

5 years

Economic life of leased equipment

10 years

Lessor鈥檚 cost

\(65,000.00

Fair value of asset at May 1, 2017

\)91,000.00

Lessor鈥檚 implicit rate

10%

Lessee鈥檚 incremental borrowing rate

10%

Instructions

(Round all numbers to the nearest cent.) Refer to the data in E21-8 and do the following for the lessor.

(b) Prepare a lease amortization schedule for Mooney Leasing Company for the 5-year lease term.

(Lessor Entries; Sales-Type Lease) Crosley Company, a machinery dealer, leased a machine to Dexter Corporation on January 1, 2017. The lease is for an 8-year period and requires equal annual payments of \(35,013 at the beginning of each year. The first payment is received on January 1, 2017. Crosley had purchased the machine during 2016 for \)160,000. Collectibility of lease payments is reasonably predictable, and no important uncertainties surround the amount of costs yet to be incurred by Crosley. Crosley set the annual rental to ensure an 11% rate of return. The machine has an economic life of 10 years with no residual value and reverts to Crosley at the termination of the lease.

Instructions

  1. Compute the amount of the lease receivable.

What are 鈥渋nitial direct costs鈥� and how are they accounted for?
See all solutions

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