the delusions of replacement cost accounting

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CFA Institute The Delusions of Replacement Cost Accounting Author(s): R. J. Chambers Source: Financial Analysts Journal, Vol. 33, No. 4 (Jul. - Aug., 1977), pp. 48-52 Published by: CFA Institute Stable URL: http://www.jstor.org/stable/4478051 . Accessed: 12/06/2014 20:39 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp . JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact [email protected]. . CFA Institute is collaborating with JSTOR to digitize, preserve and extend access to Financial Analysts Journal. http://www.jstor.org This content downloaded from 185.44.78.144 on Thu, 12 Jun 2014 20:39:02 PM All use subject to JSTOR Terms and Conditions

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Page 1: The Delusions of Replacement Cost Accounting

CFA Institute

The Delusions of Replacement Cost AccountingAuthor(s): R. J. ChambersSource: Financial Analysts Journal, Vol. 33, No. 4 (Jul. - Aug., 1977), pp. 48-52Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4478051 .

Accessed: 12/06/2014 20:39

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .http://www.jstor.org/page/info/about/policies/terms.jsp

.JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range ofcontent in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new formsof scholarship. For more information about JSTOR, please contact [email protected].

.

CFA Institute is collaborating with JSTOR to digitize, preserve and extend access to Financial AnalystsJournal.

http://www.jstor.org

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Page 2: The Delusions of Replacement Cost Accounting

by R.J. Chambers

The DelSusion of Replacement Cos

Accounting

o. In a recent article in this Journal, Professors Van- cil and Weil argued that provisions for depreciation based on the replacement cost of assets will be suf- ficient to maintain the firm's physical capacity, pro- vided the proceeds from reinvestment are taken into account. They call income reported on the basis of such depreciation "distributable income."

Vancil and Weil are able to support this conclu- sion in their one-machine example only because they do not include in distributable income the rein- vestment income from their replacement fund. But on what grounds should income from the machine be distributable and income from the replacement fund not be distributable?

And how meaningful is the concept of dis- tributable income? "An important characteristic of distributable income from operations is that it is sus- tainable," say Vancil and Weil. "If the world does not change, the company can maintain its physical capacity next year and have the same amount of dis- tributable income that it had this year." But the world does change. Products and preferences for products change. Production techniques change. For a number of reasons a firm may choose not to maintain physical capacity, or find it possible to maintain physical capacity more cheaply than before.

Whatever else may be said about distributable income, it is hypothetical or, as Paul Rosenfield has

termed it, "subjunctive." Its amount represents as- sumptions abQut the form of replacement for present assets, the apportionment of an investment in new plant between "maintaining former capacity" and "new investment," and prospective service lives and scrap values. .

IN a recent article in this journal, Professors Richard Vancil and Roman Weil claimed that, under a replacement cost accounting system

(RCA), the provisions for depreciation based on re- placement costs of assets at the end of each year will be sufficient to maintain the firm's physical capacity.' They assert that my contention to the op- posite effect contains a fatal flaw. The flaw, they al- lege, lies in its failure to take into account "the return on reinvesting the assets retained because of depreciation charges." This article challenges Vancil and Weil on this point and shows that, even with reinvestment taken into account, RCA does not have the attributes its supporters claim and, in fact, possesses some fundamental defects.

Replacement Cost Depreciation Is Not Enough

Take, as a simple example, the firm with one machine that cost $1,000 and whose replacement cost rises by $100 each year. The machine has an ex- pected and actual four-year life, at the end of which it will be replaced. The machine has no scrap value at the end of the fourth year.

The RCA depreciation charges against revenues each year entail accumulation of a like amount of cash. Proponents of RCA contend that these charges will be sufficient to provide for the replacement of

R.J. Chambers is Professor of Accounting, The Uni- versity of Sydney, Australia and author of Accounting, Evaluation and Economic Behavior (Englewood Cliffs: Prentice-Hall Inc., 1966) and Accounting Finance and Management (Arthur Andersen & Co., 1969). 1. Footnotes appear at end of article.

48 El FINANCIAL ANALYSTS JOURNAL / JULY-AUGUST 1977

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Page 3: The Delusions of Replacement Cost Accounting

the machine at the end of its life. This assumes that income after depreciation is wholly paid out each year in taxes and dividends. It also assumes that the accumulating cash balance is retained as cash-that being the safest way to ensure that the cash provided remains available at the end of the fourth year. Table 1 shows the relevant figures. Obviously, my conclu- sion holds: The firm would not be able to replace the machine- at $1,400-with the $1,250 retained.

TABLE 1

Year-end 0 1 2 3 4

Purchase price 1,000 Replacement cost 1,100 1,200 1,300 1,400 Depreciation on repl. cost 275 300 325 350 Accumulated cash 275 575 900 1,250

But suppose the cash is reinvested. Suppose also that the firm initially purchases for $10,000 one machine, A, with an expected and actual service life of four years, and with no scrap value at the end of that time. Suppose that it successively reinvests the amount of the RCA depreciation charges each year in assets B, C and D, with expected service lives of three, two and one years, respectively, so that the whole amount of the depreciation charges for all four assets becomes available at the end of the fourth year. Suppose that, as in the Vancil and Weil exam- ple, the cumulative replacement costs of all assets rise at 10 per cent per annum, and suppose that all distributable income ("rent less RCA depreciation charges," as defined by the Vancil-Weil "steady- state" example) is paid out each year in dividends and taxes. Table 2 shows the relevant figures.

By reinvesting the RCA depreciation charges, the firm will certainly have accumulated enough money to replace machine A at the end of the fourth year. But, just as certainly, it will not have accumulated enough money to replace B, C and D. In Year 5 it will be forced to cut back its operating or rent-eam-

ing capacity by over one-half! Clearly any firm that supposes it can rely on RCA to secure itself against excessive distributions of cash, or to secure the year- by-year maintenance of its opening operating capacity, will be seriously deluded.

Furthermore, the Vancil-Weil single-asset exam- ple is shored up by an extra piece of business. In- stead of reinvesting in the business (as is the case in the above example, and in the Vancil-Weil steady- state example), the reinvestment is treated as a "re- placement fund," the income from which is not dis- tributable and not distributed. But on what grounds should the net income from the machine be dis- tributable and the net income from the replacement fund be not distributable, when both are income- earning assets of the company? And how is it that the single-asset firm calculates distributable income dif- ferently (i.e., exclusive of replacement fund earn- ings) from the steady-state firm (which contemplates no replacement fund)?

The two notions of income and the two modes of calculation show up a fundamental inconsistency in the Vancil-Weil examples. The isolation of the re- placement fund and the exclusion of its income from the firm's income simply serves to make the whole apparatus (RCAplus the replacement fund) do what Vancil and Weil claim RCA depreciation can do by itself.

The Steady-State Firm If the RCA depreciation charge is indeed inade- quate, without supplements, to secure the mainte- nance of the physical capacity represented by one machine, it must necessarily be inadequate to main- tain a series of machines; the accounting for a series of machines is merely a series of replications. Even when the total number of machines remains constant there will still be deficiencies as long as replacement costs continue to rise.

The Vancil-Weil example relates to a firm that builds up a stock of four machines by yearly pur-

TABLE 2

Year-end 0 1 2 3 4

Purchase price 10,000(A) 2,750(B) 4,033(C) 6,655(D)

Replacement cost A 11,000 12,100 13,310 14,641 B 3,025 3,328 3,660 C 4,436 4,880 D 7,321

Depreciation A 2,750 3,025 3,328 3,660 B 1,008 1,109 1,220 C 2,218 2,440 D 7,321

Total depreciation* 2,750 4,033 6,655 14,641

Reinvested; see purchase price above.

FINANCIAL ANALYSTS JOURNAL / JULY-AUGUST 1977 O 49

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Page 4: The Delusions of Replacement Cost Accounting

chases of one machine and, after the fourth year, retires one machine and buys another each year. By reason of the RCA depreciation charges on four machines against the revenues of that year, the cash available in the fourth year equals the purchase price of a new machine at the end of that year. Hence, Vancil and Weil say, the RCA depreciation charges can maintain a stock of four machines indefinitely. Their replacement cost balance sheet appears to support this: At the end of the fourth year the firm has 10 years of machine life at its disposal (for the machines, in order of purchase, one, two, three and four years respectively) and the depreciated asset balance is 10/1 6th's of the then replacement cost of four machines.

Unfortunately, appearances can delude. When the replacement cost of an asset rises, all previous depre- ciation charges (based on earlier replacement costs) will be inadequate to provide for replacement at the latest price. In the first example above, retaining cash equal to the depreciation charges up to the end of the second year provides $575; whereas, with half the life of the machine expired, it should have pro- vided half the replacement cost, or $600. The defi- ciency is the depreciation backlog referred to in most expositions of RCA. The backlog is admitted by Vancil-Weil, but appears to be made good in Ex- hibit 2 by their "credit for catch-up depreciation."

The only way a deficiency in cash retention can be made good is by getting cash from some other place- e.g., by retaining cash out of the revenues of some other year. But RCA rules, which entail charg- ing only cprrent costs against current revenues, for- bid this. Bookkeeping must therefore be so arranged that it appears to make provision for the backlog by:

(a) Increasing the asset account by an amount equal to the increase in replacement cost for the year (a debit entry); making a corresponding credit entry in an unrealized holding gains account.

(b) Charging against the year's revenues the year's depreciation based on replacement cost; making a corresponding credit entry in an accumulated depreciation account.

(c) Reducing the balance of the unrealized holding gains account by the difference between histori- cal cost depreciation and replacement cost de- preciation (a debit entry); making a corre- sponding credit entry in a realized holding gains account. As the charges against revenue in (b) provided a like amount, it is treated as realized.

(d) Increasing the accumulated depreciation ac- count by the amount of the backlog deprecia- tion (a credit entry); making a corresponding debit entry in the unrealized holding gains ac- count.

These entries are implicit in the Vancil-Weil exhibit. Actually, the balance of the unrealized holding

gains account is strictly a fiction. While the replace- ment price of the assets did rise, this did not intro- duce any new cash or money into the firm. Charging against this balance the amount of the depreciation backlog is nothing like charging depreciation against revenues that do introduce cash or money's worth. Accumulated depreciation, which matches so well the expired machine lives, is also part fiction.

Vancil and Weil admit the fictional character of some elements of the RCA system. They contem- plate the possibility that earnings from their "re- placement fund" may fall short of the funds re- quired; "but the definition of distributable income would not be affected."' Which only goes to show that the definition must be defective in some way, for nothing can be replaced out of negative surplus. Vancil and Weil also refer to the separation of "real from fictional (or nominal) holding gains"; Yet neither they nor anyone else has yet proved that in- clusion of fictions in balance sheets or income ac- counts improves their utility. Unless and until re- porting of fictions is abandoned, accounting will not serve investors, analysts and others as it should.

The failure of depreciation charges to recover the backlog does not show up in real terms in the Van- cil-Weil example because the example is a section of an exponentially increasing and infinite series, in which the effects of not recovering the backlog are put off to infinity. The example shows that cash flows can continue to replace assets, not that depre- ciation charged on an RCA basis will secure the maintenance of physical capital. This is evident from the fact that the replacement fund was a necessary crutch in the case of the single-machine example.

All that apart, the Vancil-Weil suggestion that the proceeds of reinvestment must be taken into account implies a curious and unrealistic mode of managing investments in assets. Ordinarily, all investments in assets will be made after appraisal of the merits of al- ternatives by exploratory present value and bud- getary calculations. The decision will be based on the relative merits of the proposals in their own right, not as part of a "package deal" for counteract- ing some inadequacy in price-making or in the de- preciation accounting for other assets. The package deal notion would make project appraisal an exer- cise in incestuous calculations from which no clear conclusion could emerge.

It may seem simple enough in the highly reduced examples we use for illustration (single-asset, steady- state, etc.), but, in a company with many assets of different styles and service lives, it would be quite impossible to determine which part of the expected proceeds of a new investment will make good a defi-

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Page 5: The Delusions of Replacement Cost Accounting

ciency (backlog) on a past investment and which part will become genuine, additional net proceeds. The very existence of a backlog- admitted in expo- sitions of all varieties of RCA-involves a con- tinuous series of exercises in robbing Peter to pay Paul. Even when backlog depreciation can be charged against retained profits, no reader of the ac- counts could safely assume that the profits are avail- able for distribution; they would be subject to future whittling as new backlogs wre charged against them.

There was no flaw in my argument or conclusion. Vancil and Weil answer the wrong question-are cash flows adequate?- instead of the question at issue- are depreciation charges adequate? The flaw in their argument (for to confuse net income with cash flows is surely a flaw) is compounded by the auxiliary replacement fund, which on their own ad- mission will not necessarily make good the defi- ciency arising under the pure RCA system.

The Defects of RCA

The whole groundwork of replacement cost ac- counting does not suit the purposes to which pub- lished financial information is applied.3 Most in- vestors understand a balance sheet as a statement of dated financial position. On the one hand it repre- sents assets in possession, on the other it represents lenders' and owners' interests in those assets. In- vestors commonly see it as an indicator of whether there are sufficient assets to meet debts or to con- form with the terms of bond indentures. It can only do so, however, if the amounts representing assets are amounts of money available or accessible (by sale of non-monetary assets); only such amounts are indicative of capacity to meet debts, running costs, taxes, dividends and so on. This implies that non- monetary assets should be reported at resale prices, not purchase (replacement) prices.

A replacement price represents what a firm would have to pay to replace an asset if it were to replace the asset. That is, if anything, a contingent obliga- tion-just the opposite of what assets in balance sheets supposedly represent. In budgeting, indica- tions of what is available are based on available money and the selling prices of assets (inventories and other things); indications of proposed spending are given by purchase prices. It would be absurd to reverse these prices. Yet in balance sheets-the starting points of subsequent budgets- RCA does precisely this.

Replacement costs can represent elements of fi- nancial position only when the markets in the firm's assets are perfect markets in equilibrium; only in that case will replacement price equal selling price, hence indicate financial capacity to carry on busi- ness. Of course, there are no such markets.

There are numerous other aberrations. Suppose the balance sheet of a company showed as assets cash, $10,000; machines at replacement cost; total, $30,000. The cash represents available purchasing and debt-paying power; the replacement cost of the machines, as we have said, does not. As the two figures are not of the same kind, their aggregate is meaningless. Suppose, further, that the balance sheet listed several classes of assets at replacement or de- preciated replacement cost, plus cash and receiv- ables; and suppose that an analyst wished to assess the risks to which the company's asset holdings were subject. He would want to know the proportion of asset holdings subject to different kinds of risk. Since the asset aggregate is meaningless, however, the pro- portions would also be meaningless.

"An important characteristic of distributable in- come from operations," say Vancil and Weil, "is that it is sustainable. If the world does not change, the company can maintain its physical capacity next year and have the same amount of distributable in- come that it had this year. Because distributable in- come has this characteristic it is important to finan- cial analysts." But the world does change; products and preferences for products change; production technique changes. For a number of reasons, a firm may deem it wise not to maintain physical capacity, or find it possible to maintain physical capacity more economically than before. For a score of gen- eral reasons affecting costs and revenues there is no ground for believing that any reported income is sus- tainable.

Whatever else may be said about it, distributable income is hypothetical or, as Paul Rosenfield has called it, "subjunctive." Its amount rests on assump- tions about the form of replacement, when present assets are not physically replaceable; the apportion- ment of an investment in new plant between "main- taining former capacity" and "new investment," when it provides increased or different capacity; the prospective service lives and scrap values of plant and other assets. All these things determine the RCA depreciation charge. It also rests on the meaning of capacity. The SEC Rule 190 refers to capacity to produce and distribute (see Staff Accounting Bulletin 7), which differs significantly from physical capacity to produce.

The SEC Rule 190 is wise in being so vague about specific forms of calculation. But, in being so vague, it leaves a vast range of imaginative calculations open to firms reporting under the Rule. When so many possible assumptions may be made, it is a little ridiculous to suppose that RCA income measures sustainable income-or even that it legitimately measures past earned income, which is what re- ported income is usually expected to do.

FINANCIAL ANALYSTS JOURNAL / JULY-AUGUST 1977 O 51

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Page 6: The Delusions of Replacement Cost Accounting

Past performance is indicated by rate of return, the relationship of net income to net assets (assets less liabilities). If RCA net income is hypothetical, and the asset aggregate is meaningless, rate of return must be nonsense. There is certainly no way to relate it to the rate of return on a money contract, such as a bank interest rate or a bond rate, which is the com- mon way of assessing investment performance.

Leverage, or the debt to equity ratio, is significant only if the amounts of debt and equity are measured consistently. Whereas debt represents a genuine amount of money payable, however, the aggregate owners' equity depends on valuations placed on assets (total assets less debt equals equity). If the total amount shown for assets is meaningless, so is the amount shown for equity. The debt to equity ratio is therefore misleading. Indeed, because of the hypothetical elements of RCA, management may set a very high value on assets and, simply by doing so, increase their freedom to borrow under any such constraint as a multiple of owners' equity. History has witnessed enough salutary examples of borrow- ing on assets stated at greater than their money equivalents to serve as warning against increasing the possibilities of so doing.

RCA does not deal with the problem of inflation, despite the fact that it came to prominence because of concern with that problem. It deals only with changes in the costs of tangible, non-monetary assets. If wages or other costs rise, if selling prices and receivables balances rise, what happens? How can investors reading an RCA statement tell whether a company is better off than before (i.e., has earned income)? The Vancil-Weil examples, and most other expositions of RCA, ignore such results of in- flation.

Further, if the general purchasing power of money falls, the purchasing power of the dollars repre- senting the opening amount of net assets will fall and

the firm must hold an additional number of dollars at the end of the year before it is better off than at the beginning. This additional number would equal the product of opening net assets (expressed in money equivalents, not replacement prices) and the propor- tionate change in an index of the general level of prices. RCA takes no notice of this either.

As a method of reporting results and positions from time to time, RCA has numerous flaws. Other authors have dealt with these defects at greater length elsewhere.4 By contrast, continuously con- temporary accounting, referred to as CoCoA in my article (cited by Vancil-Weil), has none of these de- ficiencies and a number of distinctive merits that recommend it to investors and analysts.5 a

Footnotes

1. Richard F. Vancil and Roman L. Weil, "Current Re- placement Cost Accounting, Depreciable Assets and Distributable Income," Financial Analysts Journal (July/August 1976).

2. Ibid., p. 42. 3. My article, "NOD, COG and PuPU, See How Infla-

tion Teases," Journal of Accountancy (September 1975), hints at this defect.

4. Particularly in Chambers, Current Cost Account- ing -A Critique of the Sandilands Report (Interna- tional Centre for Research in Accounting, University of Lancaster, 1976). See also footnote 5.

5. CoCoA is described in Chambers, Accounting for In- flation (Exposure Draft and Workbook), Department of Accounting (H04), University of Sydney, Australia 2006, $5 incl. postage. A 24-point comparison of the relative merits of general price level accounting, RCA and CoCoA, mainly from the viewpoint of investors, creditors and analysts, is given in Accounting for In - flation. See also Chambers, Securities and Ob- scurities, available from Department of Accounting (H04), University of Sydney, Australia 2006, $5 incl. postage.

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