An Evaluation of Replacement Cost Accounting

An evaluation of replacement cost accounting

As a method of financial reporting, the objective of replacement cost accounting is to provide a concept of income which will satisfy the criteria of relevance and feasibility which were discussed earlier.

Replacement cost income is more relevant to investors than accounting income for the purpose of decision making. First, it provides for the maintenance of the service potential of capital by charging against revenue the cost of replacing the assets exhausted in earning revenue. Second, an important distinction is made between operating income and holding gains, thereby allowing investors to appraise the firm as a going-concern. Third, it recognizes changes in the value of assets, since they are related to current market prices. For these reasons, investors are provided with information which is more relevant than accounting income for evaluating the business, and they are placed in a better position to predict the future. By providing more accurate valuations of assets in use, replacement cost accounting is likely to lead to a more efficient allocation of financial resources than that afforded by conventional accounting methods. A further argument in favour of replacement cost accounting lies in the diversity of values found in conventional accounting due to the employment of a variety of valuation methods, such as LIFO, FIFO or average cost. With replacement cost accounting, however, values are uniformly derived from the current replacement cost of specific assets, so that comparisons are much more meaningful.

As regards the criterion of feasibility, Dickerson ( 2014) has shown that replacement cost accounting is not too time consuming and costly for practical implementation. Applying himself to the problem of converting data from historical cost to replacement cost for a small producer of moulded plastic articles, he reported that 95 hours of work were involved in that translation, of which 40 hours were spent on familiarizing himself with the data.

Criticisms are sometimes advanced against replacement cost accounting on the ground that the measurements involved are subjective. There exist, however, Government Indices which relate to fixed assets of various kinds which may be employed for the purpose of calculating the replacement cost of specific fixed assets. The Sandilands Committee recommended that the Government Statistical Service should publish as soon as possible a new series of price indices specific to particular industries for capital expenditure on plant and machinery. Such a series of indices should be designed to provide a 'standard reference basis' for making reasonable approximations of current replacement costs. The derivation of replacement costs for inventories could present problems. However, when the various different methods of valuing inventories at the present time are considered, it appears that replacement cost provides a more objective measure. Another criticism made by Sterling (2000) is that replacement cost measurements imply the substitution of specific asset values for money measurements, thereby abandoning a common unit of measurement.

A major problem arises, however, during periods of rapid technological change. Most authorities argue that since a measure of the profitability of existing operations is required, current replacement costs should be measured in terms of the market prices prevailing for the actual fixed assets which are exhausted in producing income. Some authorities are opposed to this view since it seemingly ignores the effect of technological change. They argue that the replacement cost of new generation assets should be used, because 'the primary interest is in the long-run prospects of the firm, and there seems to be no particular reason why these long-run prospects would be indicated by the prospects of the present mode of production, when becoming obsolete'. Accordingly, if the firm is using a second generation computer made obsolete by the development of third generation computers, they argue that the current replacement cost should be based on the current market price of third generation rather than second generation computers.


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Read on: Basic Current Value Accounting Concepts

Basic Current Value Accounting Concepts

The basic concept underlying replacement cost accounting is that the firm is a going concern, which is continuously replacing its assets. Therefore, the cost of consuming such assets in the income generation process should be equivalent to the cost of their replacement. Replacement cost accounting differs from current purchasing power accounting in that it is concerned with the manner in which price changes affect the individual firm. It focuses on the specific commodities and assets employed by the firm by taking into account changes in the price... see: Basic Current Value Accounting Concepts