Replacement Cost Accounting

Replacement cost accounting is an accounting method which allows for additional depreciation on some part of the difference between a depreciable asset's original cost and its replacement cost. This cost accounting method values assets and liabilities at their cost to replace. The replacement cost accounting method replaces the historical cost accounting. Under this method the effect of inflationary changes on items bought and sold are considered. The holding gains and losses arise from a change between the accounting methods. This accounting method also allows an additional depreciation on part of the difference between the original cost and current replacement cost of a depreciable asset.

Under the traditional accounting standards the company would be required to record an asset at the original purchase price, determine the asset’s salvage value and calculate monthly depreciation from the difference between these two numbers. The company’s balance sheet would reduce the asset’s historical value i.e. the original cost of the asset and present a true value of the asset on the financial statement. In practice the historical cost does not represent what a company would pay to purchase another item to replace the original, as replacement cost accounting requires.

The fair market value is similar to the replacement cost accounting method. The difference is that the fair market value must be re-valued at various times through the year to a value at which the company could sell the asset in the open marketplace. The Replacement costing method tries to smooth the differences by allowing companies to value assets at specific time periods, similar to fair market value accounting and at the actual cost of asset replacement. The replacement cost accounting requires companies to take the holding gains or losses from the asset revaluation and recognize them as extraordinary gains or losses on the income statement. This is beneficial as the companies assets that go up in value, but on the other side the declining values can bring down the company’s accounting income and to the business stakeholders.

Questions

• What is replacement cost accounting?
• What is the difference between the replacement cost accounting and fair market value?