Question

Many organisations measure their property, plant and equipment at cost, less accumulated depreciation and accumulated impairment losses (while other organisations might measure their property, plant and equipment at fair value). You are required to discuss some of the problems associated with basing depreciation expense on historical cost (rather than some other value, such as replacement cost). You are also required to explain why managers might prefer to measure property, plant and equipment using the cost model rather than measuring the assets on the basis of fair value.

Answer 1

Problems in using historical cost in lieu of replacement cost:

1] The depreciation provided on historical cost will not

represent the true value of the dimunition in the value of

the asset. The true value should be the depreciation based

on replacement cost as that is the real reduction in the value

of the asset.

2] Depreciation, being a non cash expense, is also meant to

retain profits to provide for future replacement of the assets.

If depreciation is provided on historical cost, the profits so

retained would be inadequate to replace the asset in future

as the prices would have gone up.

Mnagers preference for depreciation using cost model:

*If replacement cost is used for depreciation, the profits

would be lower. Reporting lower profits would affect the

evaluation of rewards to the managers.

*The depreciation would keep on increasing as the

replacement prices would go up year after year.