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b) Replacement cost accounting (RCA) is the amount of money required to replace an existing
asset with an equal valued or similar asset at the current market price, or in other words, it is a
cost of purchasing a substitute asset for the current asset being used by a company. A practice in
which liabilities and assets are recorded on a balance sheet according to the cost of replacing
them, rather than the original amount spent on liabilities or assets. This practice is intended is to
take into account current prices when calculating a company’s value. It is the opposite of historic
cost accounting. Replacement Cost Accounting (RCA) is an improvement over Current
Purchasing Power Technique (CPP). One of the major weaknesses of Current Purchasing Power
technique is that it does not take into account the individual price index related to the particular
assets of a company. Easton et al (1991) have the view that Replacement Cost Accounting, the
index used are those directly relevant to the company’s particular assets and not the general price
index. In this sense the replacement cost accounting technique is considered to be an
improvement over current purchasing power. But adopting the replacement cost accounting
technique will mean using a number of price indices for conversion of financial statements and it
may be very difficult to find out the relevant price index to be used in a particular case. Further,
the replacement cost accounting technique provides for an element of subjectivity and on this
ground it has been criticized by various thinkers.
Net realizable value approach (NRVA) also known as current exit cost. NRV model is based
on the economist’s concept of opportunity cost. Basically, all assets are entered at the net
proceeds that could be generated by their sale. Their closing down sale price. It is the estimated
selling price of goods minus cost of their sale or disposal. There is ongoing need to assess the
value of the inventory to see if its recorded cost should be reduced due to negative impacts of
such factors as damage, spoilage, obsolescence and even reduced demand from customers.
Writing down inventory prevents a business from carrying forward any losses for recognition in
a future period. Thus the use of net realizable value is the way to enforce the conservative
recordation of inventory assets value. The virtues of NRVA is that it avoids the need to estimate
depreciation and, in consequence, the attendant problems of assessing life-span and residual
values. Depreciation is treated as the arithmetic difference between the NRV at the end of a
financial period and the NRV at its beginning. Also it is based on opportunity cost and so can be
said to be more meaningful. It is the sacrificial cost of possessing an asset, which, it can be
argued, is more authentic in terms of being a true or real cost. If the asset were not possessed, its
cash equivalent would exist instead and that cash would be deployed in other opportunities.
Therefore, NRV = cash = opportunity = cost.
Current Purchasing Power (CPP). Under the CPP method, monetary items and non-monetary
items are separated. The accounting adjustment for monetary items is subject to the recording of
a net gain or loss. Non-monetary items (those that do not carry a fixed value) are updated into
figures with a conversion factor equivalent to price index at the end of the period divided by
price index at the date of transaction. All figures in financial statement are restated via relative
price index in terms of how many current shillings are now necessary to buy, at the balance sheet
date, the same amount as they would have bought when the item first entered the focal
organization’s records. In this type of accounting price level, Desai (2005) discuss the various
items of financial statements, i.e. balance sheet and profit and loss account are adjusted with the
help of recognized general price index. The consumer price index or the wholesale price index
prepared by the Reserve Bank of respective country can be taken for conversion of historical
costs.
The main objective is to take into consideration the changes in the value of money as a result of
changes in the general price levels. It helps in presenting the financial statements in terms of a
unit of measurement of constant value when both cost and revenue have been changing due to
changes in the price levels.
In the past few years of high inflation, companies have reported very high profits on the one
hand but on the other they have faced real financial difficulties. This is so because in reality
dividends and taxes have been paid out of capital due to overstated figures of profits arrived at
by adopting historical cost concept. Thus a change from historical cost concept to price level or
inflation accounting has been recommended.
According to Gjerde, (2007) the financial statements prepared under this technique provide more
realistic information and make a distinction between profits earned from business operations and
the gains arising from changes in price levels. Balance Sheet reveals a more realistic and true and
fair view of the financial position of a concern because the assets are shown at current values and
not on distorted values as in historical accounting.
Profit is not overstated as inflationary changes in the value of assets are not ignored. Investors,
employees and the public at large are not misled by inflated book profits because inflation
accounting shows more realistic profits. Higher paper profits without adjustment for price level
changes cause resentment among workers and they demand higher wages and also excessive
profits attract new entrepreneurs to enter the business. Inflation accounting helps in avoiding
further competition from prospective entrepreneurs.
Comparability of business entities, which is so necessary in the assessment of performance and
growth, becomes possible. When financial statements are presented, adjusted to the price level
changes, it makes possible to compare the profitability of two concerns set up at different times.
The decision-making process, the formulation of plans and the setting of targets may become
optimal because financial base data are relevant.
It entails recognition of unrealized profit, a practice that is not possible in the traditionalist. All
these are possible due to the fact that in current cost accounting the fixed assets are shown in the
balance sheet at their current values and not on historical costs. The depreciation is charged on
the current values of the fixed assets and not on original costs. Inventories or stocks are valued in
the balance sheet at their current replacement costs on the date of the balance sheet and not cost
or market price whichever is lower. The cost of goods sold is calculated on the basis of their
replacement cost to the business and not on their original cost. The surpluses arising out of
revaluation are transferred to Revaluation Reserve Account and are not available for distribution
as dividend to the shareholders. And lastly but not the least, In addition to the balance sheet and
profit and loss account, an appropriation account and a statement of changes is prepared.
d). Main reasons why the standard setters have experienced so much difficulty in their attempts
to develop an accounting standard on accounting for changing prices
Some people had opinion that inflation accounting may create more problems than solving them
because of the following inherent demerit of accounting price level changes:
ii) Price level accounting involves many calculations and makes financial statements so
complicated and confusing that it becomes very difficult for man of ordinary prudence to
understand, analyze and interpret them.
iii) The concept of price level accounting appears to have more theoretical importance than
practical because adjusting the accounts to the changes in the price levels may lead to window
dressing of accounts due to the element of subjectivity in it. People may adjust the accounts
according to the values most suited to them, thereby, making the financial statements more
inaccurate.
iv) During deflation, when the prices are falling, adjustments of accounts to price level changes
will mean charging lesser depreciation and overstatement of profits
v) Considerable subjectivity is involved in identifying suitable specific price level indices for
each of the possible specific price changes. The resulting reduction in reliability together with
the costs of implementing the approach with all its complexities are considered to outweigh the
advantages, particularly where the period of holding assets is relatively short and hence the
impact of the adjustments is small.
REFFERENCES
Bebbington J. et all. (2001). financial accounting: practice and principles (3rd edition). Cengage
Learning EMEA
Gitman, Lawrence J. (2004), “Effects of Inflation and Principles in Managerial Finance”, Parson
Education, pp. 560-590.
Mosich, A. N. and Larsen, E. John. (1982) Intermediate Accounting.(5th Edition). New York
and other major cities: McGraw-Hill Book Company.