Question

Scenario:

Your company purchased some expensive, sophisticated equipment in January of Year 5. The cost was $2,000,000  and the equipment was expected to have a useful life of 10 years. Now, in Year 6, the company has spent an additional $1,000,000 on the same equipment. $400,000 of this total was on ordinary repairs to fix things in order to maintain expected operating condition. However, the other $600,000 was spent on extraordinary repairs, which consisted of replacing the original engine so that the useful life of the entire equipment will be extended another five years. Company management was to "capitalize" the entire $1,000,000.

Write a memo around one page in length to your supervisor that explains the following:

• The accounting error that has been made

• The effect this error will have on the company's financial statements this year

• The problems that might result

• The importance of fixing the error and what needs to be done to fix the error

• General outline of the memo:

  Traditional Memo Header to Me from You with a nice summary title and date

  para 1 - What is the problem and what is the impact - one or two sentences

  para 2 - What should have happened - can be done as one sentence with a journal entry view

  para 3 - How to adjust - once sentence with a journal entry view

  para 4 - What should be done for the future monthly depreciation - one sentence showing the calculation with a journal entry

  para 5 - Closing statement - one or two statements and request for review and approval

Answer 1

Date: XX/XX/XXXX

To : Supervisor

From: Your name

Subject: Request to rectify the accounting error made on capitalization of repairs

I am writing to inform you regarding the wrong capitalization of ordinary repairs done to the equipment. Any costs incurred which will increase the useful life of the equipment only needed to be capitalized. The costs of recurring nature or ordinary repairs should be charged to income. The cost incurred amounting $400,000 was actually charged to revenue as repair expenses instead of capitalizing the same by adding to the cost of equipment. This error will overstate the cost of fixed assets and depreciation expense. The income will be overstated by not charging the repair expenses to revenue. This will make the figures of income, depreciation expense, cost of fixed assets and accumulated depreciation misleading. The users of the financial statements will be misled by this information.

The error should be corrected in order to improve the transparency and usefulness of the financial statements. The information conveyed by the financial statements should be such that it will increase the awareness of the users. Otherwise, the sole purpose of the financial statements will be undermined. The amount of $400,000 should be charged to revenue as repair expenses by crediting the cost of equipment and debiting the repair expense. Depreciation should be charged on the revised value of cost of the equipment by debiting depreciation expense and crediting accumulated depreciation.

Thank you for your understanding.