Overview

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.

Example

Year of Purchase Cost of Assets Life in years % of Dep.
2017 50,000 20 5%
2018 80,000 10 10%
2019 140,000 7 15%

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.

Solution

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
270,000 400,000

Ledger Adjustment

Journal Entries

1. Using Index No.

Dr. Cr.
Fixed Asset Account 140,000
To Cap. Res. A/c 140,000

2. Profit and Loss Account

Dr. Cr.
Fixed Asset Account 93,000
To Cap. Res. A/c 93,000

(Excess Dep. required on CPP basis)

3. Fixed Assets

Dr. Cr.
Fixed Assets 60,000
To Cap. Res. A/c 60,000

(Increased value of fixed assets on RCA basis)

Frequently Asked Questions

What is a replacement cost accounting?

Replacement Cost Accounting is an improvement over current purchase power parity (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.

What are the benefits of a replacement cost accounting?

Rca requires the appropriate index numbers to be used when replacing old assets, which means it does not result in any loss. By using rca instead of cpp you make provisions based on the current costs the company will incur after years of use for an asset compared to the original cost of that asset.

What is the process for a replacement cost accounting?

The first step in the replacement Cost Accounting process is to identify all Fixed Assets and their corresponding original purchase price and index number. The second step is to calculate Depreciation on an annual basis, using either the historical cost or current purchasing power methodologies. The final step is to adjust the Fixed Assets account by those amounts.

What are the limitations of a replacement cost accounting?

The main limitation with replacement Cost Accounting is that it only works well under certain circumstances, such as when there has been no capital gains tax and indexation has not played a part in any real property investment decisions. It is also important to note that replacement Cost Accounting should not be used for intangible assets.

What is the main difference between replacement cost accounting and current purchase power parity?

The key difference between replacement Cost Accounting and current purchase power parity is that cpp uses the general price index, which may not be relevant to a particular company’s assets, while replacement Cost Accounting uses the appropriate index number. This means that rca is more accurate when compared to cpp because it calculates Depreciation on the basis of current costs rather than historical costs.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

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