In this article we will discuss about the arguments for and against replacement cost basis of depreciation.
Arguments for Replacement Cost Basis:
Accountants who favour charging of depreciation on replacement cost basis give the following arguments:
1. In order to maintain the capital assets properly, it is desirable that depreciation should be charged on replacement cost basis otherwise real earned profit will not be disclosed by the profit and loss account.
2. When the value of money drops rapidly during the working life of the fixed assets book profits are inflated and are not real. Depreciation on replacement cost basis would suitably adjust the profits.
3. If depreciation is charged on historical cost basis, the charge for depreciation to profit and loss account will be less and it will show the inflated profit and can be paid away by means of dividend to the shareholders. This will prejudice the rights of preference shareholders and depreciation holders and gradually undermine the capital structure of the business.
4. If depreciation is not provided on replacement cost basis, less charge of depreciation to profit and loss account will provide insufficient funds to replace the asset at the end of its working lite and the concern may have to resort to borrowing of further capital.
5. Revenues are earned on current price basis. Hence, it will be logical to charge depreciation on replacement cost basis in order to give correct current price charge of depreciation to profit and loss account.
Arguments against Replacement Cost Basis:
Some accountants object the charging of depreciation on replacement cost basis because of certain practical difficulties, as given below:
1. The issue of replacement of an asset is distinct from writing it off by way of depreciation. For replacement of assets the management should retain sufficient profits within the business. This issue, therefore, cannot be brought under depreciation.
2. Charging depreciation on replacement cost cannot guarantee that excessive dividend will not be paid. Higher dividends can be paid by an arbitrary accounting expedient of this kind.
3. Reserves can be made on regular basis to have business stability and future capital investment. It is of no use to inject fictitious charge into profit and lost account by way of adjustment of depreciation charge after the real cost has been written off.
4. The effect of depreciation based on replacement value on cost and financial accounts cannot be readily computed irrespective of the method of depreciation in operation.
5. It is very difficult to find out the replacement cost in the beginning of the assets life. At the most, an estimate which is taken for the purpose of charging depreciation, may be more or less and may not provide correct amount of funds for the replacement of asset at the end of its working life.
6. The basis of charging depreciation on replacement cost is objected b3′ the income-tax authorities on the plea that depreciation charge to profit and loss account will be more which ultimately will reduce the profit for income-tax purposes.
7. It is very difficult to replace the same asset at the end of its working life as assets airways change in quality and type due to improvements. If estimate of the amount which is required for replacement of the asset is made on the latest model, then it will give an overcharge to profit and loss account which is not justified.
8. If depreciation is charged on replacement cost basis i.e., on the basis of some imaginary cost, it would defeat the basic accounting concept of objective evidence which, of course, can be achieved if depreciation is provided on historical cost basis.
9. Businessman and industrialists may prefer to charge depreciation on replacement cost, as due to overcharge of depreciation to the profit and loss account, it will reduce the profit for income-tax purposes but in times of depression when the prices of assets are falling, they may not agree to charge the depreciation on replacement cost as it will increase the profit due to less charge of depreciation to profit and loss account and ultimately their liability for income-tax will increase.
Due to the practical difficulties discussed above, it is desirable to provide the depreciation on historical cost basis rather than on replacement cost but the following course may be adopted to have more funds in the concern for replacement of the asset at the end of its working life.
Difference between the depreciation according to replacement cost and historical cost should be appropriated out of profit and loss appropriation account and credited to a separate account called replacement reserve account. It will be shown on the liabilities side of the Balance sheet till it is required to be used for replacement purposes.
These days when money is scarce, there are very few concerns which invest the provision for depreciation in outside securities so that it may be available at the time of replacement of assets. Most of these funds are used to meet the requirements of working capital for expansion or modernisation or other programmes of a concern.