Question

You are auditing the December 31, 2018, financial statements of Atlantic, Inc., a 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, 2018, 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. The lease has a 5 years term.

2. Rental of $5,680 per year (at the beginning of each year).

3. Estimated economic life of the truck is 7 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 audit, to discuss the above situation. Please write a one-page memo to answer the following questions:

1) Identifies the problems and related issues.

2) Do you need any additional information to make decision regarding the type of the lease? Please make assumption(s) and discuss how the alternative assumption(s) may affect the lease classification.

3) Based on your assumption(s), how would 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 book

Answer 1

The following points needs mention about the absence of records for a truck -on-lease.

1)Identification of the problems and related issues:

There is a used truck , which can be classified as equipment, not listed in the equipment account or any of the Atlantic Inc.'s books--with the explanation given being, it is only being used on lease and not owned by the company.

Currently, the co. must be only recording the expense as lease rent expenses in their income statement.

Even then, it requires disclosure as footnotes to the published financial statements--which does not seem to have been done.

The lease term is for 5 years.

Under the current Accounting Standards Codifictaion -842 of the FASB, all lease arrangements for more than 12 months in length , must be disclosed within the financial statements, by creating suitable right-of-use asset & related liabilities, in the balance sheet. ASC 842 aims to reduce off-balance sheet arrangements , to the minimum.

2.Requirement of additional information to make decision regarding the type of the lease:

Let us first discuss the criteria for classification of leases as capital/finance:

A lease is classified as a finance/capital lease by the lessee,

if the terms of the lease satisfy any one of the following criteria:

the lease transfers ownership of the leased asset to the lessee at the end of the lease term

There exists a bargain purchase option ,to purchase the leased asset ,at considerably lower than FMV,which the lessee is reasonably certain to opt for.

The lease term is equal to or more than 75% of the remaining economic life of the leased asset

The present value of the periodic lease payments added with guaranteed residual value,if any ,is equal to or more than 90% of the fair value of the leased asset--- for the discounting of which, lessee's incremental borrowing rate can be used , in the absence of knowledge about the lessor's implicit rate.

As an addition in the new ASC 842,

the specialised nature of the leased asset is such that it does not have any alternative use to the lessor , at the end of the lease term.

All leases not falling under capital lease classification are operating leases & to be accounted as such.

So, discussing from the above,

Nothing is said about ownership transfer at end of lease

or existence or otherwise of the Bargain purchase option

But lease is ,5/7=71.43% < 75% of the economic life of the equipment.

PV of the lease is 5680*(1-1.1^-5)/0.1*1.1= $ 23684.84 --but we do not have the fair value of the asset , to compare, to see if it works out to 90% or not.

Hence, in the absence of the required informations,mainly the fair value of the truck,

this lease can be classified as operating lease.

3. If we assume the fair value to be 32500

the journal entry required for recording the lease initailly

under operating lease will be:

Right-of-use asset	23684.84
Lease liability		23684.84
Lease liability	5680
Cash		5680
JE at end Yrs. 1 to 5
Rent expense	5680
Lease liability(23684.84-5680)*10%	1800.48
Right-of-use asset-Acc. Amortsn.		1800.48
Cash		5680

So, the rent expense will appear in the income statement &

right-of-use asset & the corresponding lease liability will be carried in the balance shee, till the term of the lease.

On the other hand. If any of the capital lease criteria are met & the lease being treated as a capital lease,

the JEs will cover:

1. lease inception entry at PV of lease pmts.

2. the beginning of yr. lease pmt.(without interest)

3. End of yrs. 1 to 5 lease rentals pmts. With lease interest & amortisation of principle.

4. EOY 1-5 Decpreciation expense for the leased asset.