In this article, we will discuss the various merits and disadvantages associated with using three different accounting methods, namely: Historical cost basis, Net realisable value and the Replacement cost basis.
Arguably, the Net realisable value method is the most subjective accounting method around. To measure the market value of the railway, the company will probably appoint a number of private valuers to gauge the market worth of the rail track. This is an extremely subjective exercise and may open the door to abuse and possibly, collusion. As such, it is unlikely that government regulators would prefer this method, from a public interest perspective. Shareholders may be interested in finding out the Net realisable value if the company intends to sell the rail track in the near future. This could be presented for internal management reporting. It has little value for the public accounts. It is hard to see how customers would benefit from this mode of accounting.
Replacement cost reporting takes into account the cost of replacing the entire rail track. Should the value of the asset increase, an extraordinary gain would have to be reported even though there is no effect on the cash flow position of the company. The replacement cost may also be skewed by fluctuating construction costs and overall inflation. Depreciation charges would also change if the asset has to be revalued. This may distort the income figures and make it difficult for shareholders to compare the real cash-flow/income situation arising from the real operations. If used in internal management accounting, replacement cost accounting may also cause the percentage rate of return on the assets to appear artificially low, since inflation skews the asset cost upwards. This may discourage the management from making new investments. The government and users would probably take a neutral stance towards this form of accounting.
Historic cost accounting is a relatively more objective measure to adopt. However, one instance where it may be unsuitable is if the asset deteriorates at a faster rate than what is assumed under the accounting standard. For example, depreciation may be done over 10 years for historic cost accounting. However, the asset may deteriorate much faster. For example, it may need to be replaced after just 4 years due to various factors. In this case, it may be prudent for management to add a special note to shareholders and use the replacement cost method. If government financing is required, then the government would be interested in the replacement cost method as well.