(Operating Lease vs. Capital Lease) You are auditing the December 31, 2006, financial statements
of Sarah Shamess, Inc., manufacturer of novelties and party favors. During your inspection of the
company garage, you discovered that a 2005 Shirk automobile not listed in the equipment subsidiary
ledger is parked in the company garage. You ask Sally Straub, 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, 2006, with Jack Hayes 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 $2,160 per year (at the end of each year). (The present value at 8% per year is $7,154.)
3. Estimated residual value after 4 years is $1,100. (The present value at 8% per year is $809.) Shamess
guarantees the residual value of $1,100.
4. Estimated economic life of the automobile is 5 years.
5. Shamess's incremental borrowing rate is 8% 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.)
Hi; Providing you enough points to write the memo.
A lease must be classified as a capital lease if at least one of the following criteria is met:
1. The lease transfers ownership of the property to the lessee by the end of the lease term - This condition is not met.
2. The lease contains a bargain purchase option - Nothing mentioned about this
3. The lease term is equal to 75% or more of the estimated economic life of the leased property. The estimated economic life of the automobile is 5 years ...
This post addresses about the inspection, determination about the lease, and advised client to account for this lease.