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Question: Case 16-10 Spare the Rod Stellar Bright Solar (SBS or the “Company”) is a business that contr...
Case 16-10
Spare the Rod
Stellar Bright Solar (SBS or the “Company”) is a business that contracts to develop, construct, and operate solar power plants.
SBS entered into a contract to support the Big Desert solar power plant. According to the contract terms, SBS is responsible for the day-to-day operations of Big Desert as well as for general maintenance and repairs. Big Desert expects SBS to provide routine maintenance for continued operation of the plant and respond to equipment breakdowns and failures by providing immediate repairs. In addition, the terms of the contract require SBS to procure necessary materials to operate, maintain, and repair the plant. To comply with this requirement, the Company must maintain a certain level of materials and supplies (the “spare parts”) at all times.
On a regular basis, SBS reviews a listing provided by Big Desert of recommended spare
parts for various components of the solar power plant and procures the necessary parts.
Vendors deliver the parts to SBS along with a complete listing that describes the quantity
and cost of the parts provided. SBS maintains this listing and uses it to (1) track expected
usage of the spare parts and (2) determine their expected useful lives.
The spare parts consist of customized and generic parts that vary in cost, procurement
time, expected usage (i.e., emergency replacement, standard replacement), and expected
useful life. Big Desert uses the composite depreciation method for substantially all of the
plant, and it expenses all major plant maintenance.
Required:
1. How should SBS classify the spare parts that it expects to use within one year — as a prepaid/other current assets? ?
I need to prove it is Prepaid expense!
Please explain it in detail.
Explanation / Answer
A prepaid expense is the amount spent in the current accounting period for a benefit/asset that is to be consumed in the following accounting periods.
For eaxmple, ABC Ltd. pays a sum of $ 5000 on 1st July 2017 for fire insurance for a period of two years. So the amount to be expensed in the current year will be the proportional amount of insurance from 1st July 2017 to 31st Dec 2017. The remaining amount shall be treated as prepaid expense.
That is,
Expense for 2017= 5000*6/24=1250
Prepaid Expense for 2017= 5000*18/24= 3750
In the given case, SBS mantains spare parts for the routine operation and mainteance of the solar plant. The amount that SBS spends in a given accounting period for procuring the spare parts cannot be wholly expensed in the year. The spare parts actually consumed within the accounting period will be treated as an expense and the amount corresponding to the spare parts likely to consumed during the next accounting period shall be treated as a prepaid expense. This is because the amount has been spent in the current accounting period and the benefit will be received in the next period.
Other Current Assets is a residuary head that includes current assets other than cash and cash equivalents, receivables, inventories and prepaid expenses.
Since the spare parts met the criterion for being classified as prepaid expenses, they will be included under the head prepaid assets.
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