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 from valuing these items at historical value, which is what the company originally paid to purchase the item and place it into operation. Replacement cost accounting attempts to remove distortions in the company’s financial statements relating to the true value of a company’s assets and liabilities. Asset depreciation also faces differences under this accounting concept.
Traditional accounting standards would require a company 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 balance sheet would reduce the asset’s historical value (i.e. original cost) and present a true value of the asset on the financial statement. While this concept worked in theory, the historical cost does not represent what a company would pay to purchase another item to replace the original, as replacement cost accounting requires.
Fair market value accounting is similar to replacement cost accounting, but it does have stark differences that also distort the company’s financials. Under fair market value accounting, assets 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 issue is that the value a company could receive by selling the asset does not necessarily translate to the amount a company would pay for the item, creating further distortions.
Replacement cost accounting attempts to smooth out these differences by allowing companies to value assets — at specific time periods, similar to fair market value accounting — at the actual cost of asset replacement. The biggest issue here is how to accurately account for the changes in the asset’s value. Accounting rules for replacement cost work require companies to take the holding gains or losses from the asset revaluation and recognize them as extraordinary gains or losses on the income statement. While this is beneficial for assets that go up in value, declining values can drag down the company’s accounting income and rile business stakeholders.
Depreciation changes under replacement cost accounting rules because of the changing asset value. Higher values will allow companies to depreciate the asset further, which can help reduce the extraordinary gain reported on the income statement. Assets with declining value typically provide no depreciation benefits since these amounts are already expensed on the income statement.