# Replacement Cost Accounting Technique (RCA)

### Reviewed by Subject Matter Experts

Updated on February 04, 2024

## Overview

The replacement cost accounting (RCA) technique is an improvement over current purchase power (CPP).

CPP suffers from the problem that it does not consider the individual price index related to the particular assets of a company.

The RCA technique uses the index that is most directly relevant to the company's individual assets and not the general price index.

Therefore, RCA is regarded as an improvement over CPP.

## Depreciation and Replacement of Fixed Assets

Price level change can be a problem when attempting to charge depreciation on fixed assets.

The aim of depreciation is to ensure that the profit and loss account is in order and to make a provision for the replacement of the fixed asset after long-term use.

When depreciation is charged on historical cost, it will not match the cost of the replaced asset.

To clarify, let's consider an example. Suppose a machine costs \$100,000 and its lifetime is 10 years.

Depreciation is charged on the original cost, which means that after 10 years, the amount is 100,000.

However, the cost of the same machine due to inflation has increased to \$200,000, and so a problem arises in terms of how to replace it.

In this case, it is recommended that fixed assets are valued at replacement cost values.

### Example

 Year of Purchase Cost of Assets Life in years % of Dep. 2022 50,000 20 5% 2023 80,000 10 10% 2024 140,000 7 15%

In this example, the general price index number in 2022 (i.e., the base year) is 100, 200 in 2023, and 300 in 2024.

Also, the replacement costs of three assets are \$80,000, \$100,000, and \$150,000, respectively.

Required: Calculate the amount of depreciation up to 2024 on a historical cost and current purchasing power basis.

Make the necessary adjustment in the ledger using the index number and replacement cost.

### Solution

 Year Historical Cost Index Current Valuation \$ 2022 50,000 100 (50,000 x 300) / 100 150,000 2023 100,000 200 80,000 x 300 / 200 120,000 2024 140,000 300 140,000 x 300 / 300 140,000 270,000 400,000

## Journal Entries

1. Using Index No.

 Dr. Cr. Fixed Asset Account 140,000 To Cap. Res. A/c 140,000

2. Profit and Loss Account

 Dr. Cr. Fixed Asset Account 93,000 To Cap. Res. A/c 93,000

(Excess Dep. required on CPP basis)

3. Fixed Assets

 Dr. Cr. Fixed Assets 60,000 To Cap. Res. A/c 60,000

(Increased value of fixed assets on RCA basis)