financial statements of Pacific, Inc., manufacturer of water toys
You are auditing the December 31, 2017, financial statements of Pacific, 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. Noncancelable term of 5 years.
2. Rental of $5,680 per year (at the end of each year). (The present value at 10% per year is $21,532.)
3. Estimated residual value after 5 years is $2,500. (The present value at 10% per year is $1,552.) Atlantic guarantees the residual value of $2,500.
4. Estimated economic life of the truck is 6 years.
5. Atlantic’s incremental borrowing rate is 10% per year.
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.)