Replacement cost accounting values assets and liabilities at the cost to replace them, rather than their historical value. This removes distortions in financial statements, but accurately accounting for changes in asset value can be challenging. Depreciation also changes under this method.
Replacement cost accounting is an accounting concept that focuses on valuing assets and liabilities at the cost a company will pay to replace the item. This changes the traditional accounting method of valuing these items to historical value, which is what the company originally paid to purchase the item and put it into operation. Replacement cost accounting attempts to remove distortions in the company’s financial statements related to the true value of the company’s assets and liabilities. The depreciation of assets also faces differences under this accounting concept.
Traditional accounting standards would require a company to record an asset at its original purchase price, determine the asset’s salvage value, and calculate monthly depreciation from the difference between these two numbers. The balance sheet would reduce the historical value of the asset (ie, original cost) and present an actual value of the asset on the financial statement. While this concept worked in theory, historical cost does not represent what a business would pay to purchase another item to replace the original, as required by replacement cost accounting.
Fair market value accounting is similar to replacement cost accounting, but it has stark differences that also distort the company’s finances. Under fair market value accounting, assets must be revalued several times during the year to a value at which the company can sell the asset on the open market. The problem is that the value that a company could receive by selling the asset does not necessarily translate into the amount that a company would pay for the item, creating additional distortions.
Replacement cost accounting attempts to smooth out these differences by allowing companies to value assets, in specific time periods, similar to fair market value accounting, at the actual cost of replacing the asset. The biggest issue here is how to accurately account for changes in asset value. The accounting rules for replacement cost work require companies to take holding gains or losses from revaluation of assets and recognize them as extraordinary gains or losses on the income statement. While this is beneficial for assets that increase in value, declining values can drag down the company’s book income and upset business stakeholders.
Depreciation changes under replacement cost accounting rules due to the change in the value of the asset. Higher values will allow companies to further depreciate the asset, which can help reduce windfall reported on the income statement. Assets with diminishing value generally do not provide depreciation benefits as these amounts are already recorded on the income statement.
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