Estimated economic life

You are auditing the December 31, 2018, 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, 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.
    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
    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
    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 books.

Sample Solution