1 The University of Birmingham College of Social Sciences Birmingham Business School Department of Accounting and Finance Accounting Theory

(07 !7"# $eplacement Cost Accounting

The theoretical development of the replacement cost accounting (RCA) system is usually attributed to Edwards and Bell (1 !1)" This current value approach to income and asset measurement focuses attention on the business entity as a decision ma#er" This is in star# contrast with C$$ accounting which is concerned with maintaining intact the wealth of the shareholders rather than the entity" The distinction is between physical and financial capital maintenance" RCA holds that the business entity ma#es two sorts of decision (Edwards and Bell% 1 !1& '!)&

(1) those that yield a profit by combining or transforming factors of production into products whose sale value e(ceeds the value of the factors% and ()) those that yield a gain because the prices of assets rise (or prices of liabilities fall) while such assets (or liabilities) are in the possession of the firm" *n the first instance profit is developed by using factors+ in the second it results from holding factors or products"

A company may buy in raw materials and decide to convert these using machines and labour into finished goods which are then sold to customers at a profit" These sorts of decisions are deemed operational and generate operating profits or losses" ,n the

) other hand% a company may buy in raw materials and decide to hold on to them" ,r% the company may convert the raw materials into finished goods and decide to hold on to the latter" These are deemed holding decisions and generate holding gains or losses" The company holds on to the resources for the present with the ob-ective of selling the goods on at a higher price at some future date" The more of these sorts of decisions% both operational and holding% that the management of the entity ma#e correctly% the greater the combined business income of the entity in the long run" *t ma#es sense% therefore% in order to evaluate past and to help formulate future decisions% to analyse how the income of an entity was generated by separating it into these two distinct categories& operating profit and holding gains"

*n order to distinguish between these two categories of income% the assets of a business entity are valued at replacement cost (sometimes #nown as the asset.s entry value)" Assets in the balance sheet are stated at current purchase prices% i"e" what it would cost now to replace the asset% rather than at their depreciated historical cost (/ee% 1 01& 23421)&

The use of this value has been -ustified on the grounds that% until an asset leaves the entity as a result of a sale% its entry value to the entity is the only relevant one"

As will be seen later in the conte(t of deprival values% it may also be argued that replacement cost is relevant even when the asset leaves the entity as a result of a sale (but will need to be replaced)"

' The calculation of income under the RCA system involves separating income into its constituent parts 5 that arising from operating decisions and that arising from holding decisions" *n utilising replacement cost as a valuation basis for assets this income model not only abandons the historical cost concept central to 6CA but also abandons the realisation concept% to the e(tent that the adopted capital maintenance concept permits the distribution of holding gains" *ncome may be recognised before goods and services have been supplied to customers by including in the income statement the gains (or losses) on holding decisions" This is not as revolutionary a procedure as it seems at first sight" Conventional modified historical cost accounting practice already incorporates holding gains in balance sheets (consider the holding gain that is the revaluation of land and buildings) although the lac# of realisation means that any holding gain is reported as part of the revaluation reserve and not in the income statement" This is also an option under the RCA system" 7ote however that the conventional 6CA system does allow unrealised gains on foreign currency transactions to appear as realised in the income statement"

8imilarly% in the modified 6CA system the use of /*9, as a stoc# flow assumption for the valuation of closing stoc# is an attempt to match against the current period.s sales revenue the current replacement cost of the stoc# used up in generating those sales" This 6CA convention is an appro(imation to the calculation of the cost of sales on a replacement cost basis"

:E(ample& Relatively 8imple /td;

3 The e(ample above illustrates that there are a number of advantages in using the RCA system to prepare financial statements" 9or e(ample% the RCA system may be a useful aid in determining dividend and retention policy for management" This is especially true if management treat holding gains as capital maintenance or revaluation ad-ustments as opposed to distributable profits" This particular system of accounting using replacement cost is compatible with a clear interpretation of capital maintenance which sees the latter as being the physical or operating assets of the firm" The emphasis is on the measurement of operating capacity% especially if management regard distributable profits as being e<uivalent to replacement cost operating profit as opposed to total business income including holding gains" 8hareholders only receive as dividends those profits that remain once operating capacity (defined in terms of physical resources) has been maintained" Replacement cost operating profit on this capital maintenance basis is seen as being e<uivalent to maintainable 6ic#sian *ncome 7o" )"

The RCA system usefully distinguishes between operating profits and holding gains" This particular feature of the RCA model is important for investors who may use it as a tool to assess the effectiveness of management (measured using the replacement cost operating profit) but also useful for management itself in its process of self4 assessment and planning" To the e(tent that replacement cost operating profits are controllable and holding gains are not% management may wish to ma(imise replacement cost operating profit and minimise the effects of holding gains as a strategy to combat windfall losses should mar#et prices fall" ,ther managements may choose to manage holding gains positively in a similar manner to the active management of foreign currency gains and losses"

Current values are more relevant than historical costs in the valuation of the firm" The income statement and balance sheet produced under the RCA method may provide more useful information than 6CA financial statements because values are current and give investors an up4to4date view of how the business is performing" The ma-or disadvantages of the 6CA convention% misleading historical costs in balance sheets and the heterogeneous mi(ture of gains and losses in the income figure% are eliminated" The income figure consists of income for that year alone and no other"

The RCA system is feasible (and has been used in practice in the => and elsewhere) and the difficulties of implementing such a system may have been e(aggerated" ?uch of the information needed to prepare a set of RCA financial statements already e(ists within the business entity in the form of budgets and fi(ed asset e(penditure replacement programmes" *t can be argued that the RCA system builds on e(isting historical cost accounting records to produce more meaningful and relevant financial information"

6owever% the system may have drawbac#s" The e(istence of a sound historical cost basis on which to build% especially in terms of fi(ed asset and stoc# records% is a necessity but its e(istence cannot always be presumed" Additionally% its closeness to the 6CA system also has other disadvantages" 9or e(ample% replacement costs are only applied to those assets which would in any case appear in a traditional 6CA balance sheet" The RCA system e(cludes% along with the 6CA system% material intangible assets that would be included in a valuation based on future cash flows as

! opposed to balance sheet assets (such as non4purchased goodwill and a s#illed wor#force)"

*t may be that the determination of replacement cost will not always be straightforward" *n the case of assets which are part way through their useful lives% replacement cost may be the price of an e<uivalent asset in second hand mar#ets or it may be the depreciated replacement cost of a new asset" The twin factors of obsolescence and technological change complicate the problem of replacement cost determination" *n the case of specialised machinery% it may be e(tremely difficult to find or estimate a suitable replacement cost" These sorts of uncertainties introduce a certain degree of indeterminateness into the calculation of income under the RCA system"

The final <uestion that arises is as follows& how useful and how feasible is the dichotomisation of income into its separate elements of operating profits and holding gains@ The split is based upon the view that the two types of decision are separate and independent and that management has considerable freedom of choice with respect to each" The point against this dichotomisation is a simple one" ?ost companies engaged in manufacturing or retailing must hold inventory and fi(ed assets" The holding ris# of such assets is often not separable because the opportunity to shift this ris# elsewhere is simply not available" 9or e(ample% contrast the way it is possible to hedge against foreign currency ris# but not against the ris#s of stoc#holding used motor vehicles"

2 The University of Birmingham College of Social Sciences Birmingham Business School Department of Accounting and Finance Accounting Theory (07 !7"# $elatively Simple %td & $eplacement Cost Accounting Relatively 8imple /td manufactures and sells children.s puAAles and games" The company has en-oyed many years of price stability but the financial year ending '1 Becember )CCD has witnessed a number of material price changes as follows& 'rice indices( 7on current assets *nventory Eeneral prices ) *anuary 00+ 1CC 1CC 1CC ,0 *une 00+ 11) 1C 1C! ,) Decem-er 00+ 1)3 110 11)

*n response to these changes% the company has decided to prepare accounts using the replacement cost accounting system on the following assumptions& 1" Capital is to be maintained in physical terms% i"e" it is to be defined as the replacement cost of the non current assets and inventory+ )" 8ales accrue evenly throughout the year and hence all costs are to be charged against income on the basis of average replacement cost+ '" 7on current assets and inventory in the closing balance sheet are to be valued at year end replacement costs+ 3" Closing inventory represents% on average% purchases made during the last si( months of the year" 8ummarised financial statements for the year ending '1 Becember )CCD% prepared on the historical cost basis of accounting% run as follows& .ncome statement year ending ,) Decem-er 00+ Revenues Cost of sales Eross profit Bepreciation ,ther operating e(penses ,perating profit *nterest payable $rofit before ta( Ta( Retained earnings for year /000 1%CC C 21C ) C 1CC 1C0 0) 1C 2) )) 1C

Balance sheets as at ,) Decem-er 7on4current assets Current assets *nventory 7et monetary assets Total assets less current liabilities 7on current liabilities E<uity 8hare capital Retained earnings

00+ /000s 3CC )1C 11C 0CC 21 2)1 1CC ))1 2)1

000 /000s 1CC )CC 21 221 1CC !21 1CC 121 !21

$e1uired( (a) As far as the given information allows% prepare financial statements for Relatively 8imple /td for the year ending '1 Becember )CCD on a replacement cost basis maintaining capital in physical terms (defined as the replacement cost of non current assets and inventory)" Comparative figures are not re<uired" For# to the nearest thousand" (b) $rovide a detailed analysis of the total holding gains% both realised and unrealised% analysed between non current assets and inventory" Analyse the ma#e up of the replacement cost revaluation reserve" (c) Reconcile profit after ta( on a replacement cost basis as calculated in (a) above to profit after ta( on an historical cost basis" (d) Redraft the replacement cost financial statements of Relatively 8imple /td for the year ended '1 Becember )CCD on the basis that financial capital is maintained in money terms" (e) Redraft the financial statements of Relatively 8imple /td for the year ended '1 Becember )CCD on the basis that financial capital is maintained in real terms"