You are auditing the December 31, 2014, financial statements

of Hockney, Inc., manufacturer of novelties and party favors. During your inspection of the company

garage, you discovered that a used automobile not listed in the equipment subsidiary ledger is parked

there. You ask Stacy Reeder, 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, 2014, with Crown 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 $3,240 per year (at the end of each year). (The present value at 8% per year is $10,731.)

3. Estimated residual value after 4 years is $1,100. (The present value at 8% per year is $809.) Hockney

guarantees the residual value of $1,100.

4. Estimated economic life of the automobile is 5 years.

5. Hockneys incremental borrowing rate is 8% 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. 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 clients books. (It is also

necessary to include the fact that you communicated this information to your client.)