You are auditing the December 31, 2017,financial statements of Atlantic, Inc, ma

Question

You are auditing the December 31, 2017,financial statements of Atlantic, Inc, manufacturer of water toys. During your inspection of the company garage, you discovered that a used truck not listed in the equipment subsidiary ledger is parked there. You ask the plant manager, about the vehicle, and she tells you that the company did not list the truck because the company was only leasing it. The lease agreement was entered into on January 1, 2017, with Rent-a-Truck Center 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. Noncancellable term of 5 years. Bes 2. Rental of $5,680 per year (at the autof each year). (The present value at 10% per year is S21,532.) 3. Estimated economic life of the truck is 6 years. 4. Atlantic's incremental borrowing rate is 10% per year. Instructions You are a senior auditor writing a memo to your supervisor, the audit partner in charge of this iscuss the above situation. Please write a one-page memo and explain () why you inspected the lease agreement, (b) what you determined about the lease, and (o) how you advised your client to accoun record this lease properly on the client's books. t for this lease. Explain every journal entry that you believe is necessary to

Explanation / Answer

While performing a routine inspection of the client’s garage, I found a used truck which was not listed among the company’s assets in the equipment subsidiary ledger. I asked plant manager, about the vehicle, he indicated that because the truck was only being leased, it was not listed along with other company assets. Having accounted for this agreement as an operating lease, Atlantic, Inc. had charged $5,680 to 20017 rent expense. Examining the noncancelable lease agreement entered into with Rent-a-truck center on January 1, 2017, I determined that the truck should be capitalized because its lease term (5 years) is greater than 75% of its useful life (6 years). I advised the client to capitalize this lease at the present value of its minimum lease payments: $21,532 (the present value of the monthly payments)

The following journal entry was suggested:

Leased Asset Under Capital Leases .................................. 21,532
Lease Liability ..................................... 21,532

To account for the first year’s payments as well as to reverse the original entries, I advised the client to make the following entry:
Lease Liability............................................................................ 5,465
Interest Expense (10% X $21,532) ........................................... 215
Rent Expense..................................................................... 5,680

Finally, this truck must be depreciated over its lease term. Using straightline, I computed annual depreciation of $1,716 (the capitalized amount, $21,532, minus the guaranteed residual, $1,100, divided by the 5 year lease term). The client was advised to make the following entry to record 2017 depreciation:
Depreciation Expense ............................................................. 5,108
Accumulated Depreciation ............................................ 5,108

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