7. Maintenance Costs Fargo Co. has recently acquired a new stamping machine for

Question

7. Maintenance Costs Fargo Co. has recently acquired a new stamping machine for use in its manufacturing facility. Certain components of this machine are prone to wear and must be replaced, on average, once every three years at a cost of $120,000. The CFO of the company has elected to accrue that maintenance activity in advance, debiting Maintenance Expense at a rate of $40,000 per year. Research the appropriate GAAP and prepare a memo to the CFO indicating whether this treatment is appropriate and citing the Codication. If it is not appropriate, illustrate the proper journal entry.

Explanation / Answer

INTERNAL MEMO

TO:                  Chief Financial Officer

FROM:                        Accountant

RE:                  Treatment of Component’s Replacement costs of Stamping Machine

DATE:             DD/MM/YYYY

As we are aware, certain components of new stamping machine are prone to wear and must be replaced, on average, once every three years at a cost of $120,000. We have been accruing that maintenance activity, by debiting Maintenance Expense at a rate of $40,000 per year.

However, we need to look the same from the perspective of generally accepted accounting standards, which might influence our reporting to the Financial statements.

The IAS 16 Property, Plant and Equipment mentions the recognition criteria of subsequent costs incurred as follows:

            If the two basic criteria are satisfied, then the cost should be recognized as an     asset.

·         However, Day-to-day cost of the item shall be recognized in profit or loss as incurred, because they just maintain (not enhance) item’s capacity to bring future economic benefits.

It seems visible that the certain components of this machine are prone to wear and must be replaced, which makes an inevitable part without which that machine cannot work without the replacement. The cost of replacement can also be measured. Also, these costs are not in nature of regular costs for running & maintenance of the machine. Hence, both the criteria seem to be fulfilled to capitalize the cost of replacement.

Accordingly, its necessary to debit Property, Plant & Equipment A/c by 1,20,000 at time of replacement of components, & to claim the annual depreciation expenses calculated as per useful life of the machine.

I hope the that we may start implementing the above policy considering the criteria which will will be helpful to fair reporting & on many fronts. I hope you’ll consider the same . Thanks very much.

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