Under generally accepted accounting principles, the value of a company's assets is based on its historical costs. The present book value of an asset is determined by its acquisition, or historical, cost, less any depreciation. A company's financial statements will reflect this, usually valuing its assets at their present book value.
Replacement costs provide an alternative way of valuing a company's assets. The replacement, or current, cost of an asset is the amount of money required to replace the asset by purchasing a similar asset with identical future service capabilities. In replacement cost accounting, assets and liabilities are valued at their cost to replace.
If replacement costs are used to establish the value of assets, then the replacement method of depreciation is also used to adjust the value of an asset as it is used over time. Under the replacement method of depreciation, an anticipated replacement cost for the asset is estimated. The depreciation expense is then calculated as the sum of the depreciation based on the historical cost, plus a percentage of the difference between the historical cost and the replacement cost. Using the replacement method, the depreciation expense associated with an asset is based on a combination of its historical cost and its replacement cost.
When an acquiring company seeks to obtain an estimate of a target company's value before making a purchase offer, the replacement costs of the company's assets often provide a more accurate value than does the present book value of the assets. The value of an asset is intended to reflect its earnings potential. Present book value, calculated on the basis of historical costs and depreciation, does not take into account such factors as inflation, for example. Replacement costs, on the other hand, are more likely to accurately reflect economic conditions that can affect the value of a company's assets.
SEE ALSO : Cost Accounting
[ David P Bianco ]