Question

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 inventory or as a prepaid/other current asset? 2. Should Big Desert depreciate the spare parts over their estimated useful lives or expense them as consumed?

Answer 1

1.Inventories are assets held for sale in the ordinary course of business, in the process for production of such sale , in the form of materials & supplies to be consumed in the production process or in rendering of services. If you satisfy these conditions, then, spareparts may be treated as inventory.

2.Talking about an asset , an asset shall be recognized when the future economic benefits flowing through it will benefit the enterprise over a long term & the cost of such asset can be reliably measured.

3.A prepaid asset is the expense we have already expended but not yet consumed in the business process, it may be for a year and is also classified as current asset.

4.SBS : The company procures spare parts from the vendors. It maintains a listing of those parts to track their expected usage & expected life. It is its business to develop, construct & operate solar power plants. The company is using spareparts as in the form of materials & supplies to be consumed in rendering of its services. So, the spare parts shall be classified as inventory. It shall not be classified as prepaid asset because the parts are ordered when needed and consumed in the business process at that time itself.

5. Big Desert : If the spare parts only manage to maintain the current ongoing operations of an asset , then they are expenses. If spare parts provide the extention of the current useful life of the asset or add up value to an asset which shall flow to the enterprise over a long term say more than a year, then they shall be capitalized. In this case, the spare parts are being used to maintain the current useful life of the asset hence, the expenses related to spare parts should be expensed off.