Question

1. Critically evaluate the extent to which replacement cost, realisable value and economic value offer realistic alternatives to historical cost.

Answer 1

REPLACEMENT COST VS HISTORICAL COST

Historical cost has always been the most widely used measurement system. Essentially, transactions are recorded in the books of account at the date the transaction occurred.
This original cost is maintained in the books of account and not updated for any future changes in value that might occur.

Replacement cost attempts to place a realistic value on the assets of a company
It is concerned with maintaining the operating capacity of a business. Essentially, replacement cost asks the question:
what would it cost to replace the existing business assets with identical, equivalent assets at today's prices? Replacement cost is an alternative method of measuring the assets and profits of a business rather than principally a method of tackling inflation. In the Netherlands, replacement costing has been successfully used by many businesses, such as Heineken.

REALISABLE VALUE VS HISTORICAL COST

Net realisable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. Net realisable value for inventories may not be equal to fair value less costs to sell.

The difference between historical cost and net realizable value is what the allowance to reduce inventory should be. NRV is the price cap when using the Lower of Cost or Market Rule.

ECONOMIC VALUE VS HISTORICAL COST

As investors are the major users of financial statements, priority should be given to their wants, that is, which measurement they prefer- historical cost or market value. Empirical evidences show that investors want both measurements. They want reliable and transparent market value information to determine the actual value of their investment. They also want historical cost information that helps them to determine whether management has discharged the stewardship entrusted to them. Therefore, assets and liabilities should be measured and reported at market value and these measurements must be reliable, verifiable &transparent and these measurements should not be at the cost of abandoning historical cost information.

Although historical cost accounting has some distinguishing features for which its patrons think it better method for measuring assets and liabilities, it can’t provide relevant information to investors. Market value accounting can able to eliminate this limitation by providing current and inflation adjusted information to investors. Therefore, market value is the best alternative to historical cost. But there are also several significant problems within market value accounting in its current application which make more users reluctant to use market value in measuring assets and liabilities.