The replacement cost accounting (RCA) technique is an improvement over current purchase power (CPP). CPP suffers from the problem that it does not consider the individual price index related to the particular assets of a company.
The RCA technique uses the index that is most directly relevant to the company’s individual assets and not the general price index. Therefore, RCA is regarded as an improvement over CPP.
Depreciation and Replacement of Fixed Assets
Price level change can be a problem when attempting to charge depreciation on fixed assets.
The aim of depreciation is to ensure that the profit and loss account is in order and to make a provision for the reploacement of the fixed asset after long-term use. When depreciation is charged on historical cost, it will not match the cost of the replaced asset.
To clarify, let’s consider an example. Suppose a machine costs $100,000 and its lifetime is 10 years.
Depreciation is charged on the original cost, which means that after 10 years, the amount is 100,000. However, the cost of the same machine due to inflation has increased to $200,000, and so a problem arises in terms of how to replace it.
In this case, it is recommended that fixed assets are valued at replacement cost values.
|Year of Purchase||Cost of Assets||Life in years||% of Dep.|
In this example, the general price index number in 2017 (i.e., the base year) is 100, 200 in 2018, and 300 in 2019. Also, the replacement costs of three assets are $80,000, $100,000, and $150,000, respectively.
Required: Calculate the amount of depreciation up to 2019 on a historical cost and current purchasing power basis. Make the necessary adjustment in the ledger using the index number and replacement cost.
|Year||Historical Cost||Index||Current Valuation||$|
|2017||50,000||100||(50,000 x 300) / 100||150,000|
|2018||100,000||200||80,000 x 300 / 200||120,000|
|2019||140,000||300||140,000 x 300 / 300||140,000|
1. Using Index No.
|Fixed Asset Account||140,000|
|To Cap. Res. A/c||140,000|
2. Profit and Loss Account
|Fixed Asset Account||93,000|
|To Cap. Res. A/c||93,000|
(Excess Dep. required on CPP basis)
3. Fixed Assets
|To Cap. Res. A/c||60,000|
(Increased value of fixed assets on RCA basis)