Peeling away financial reporting issues one layer at a time

What I Mean by “Replacement Cost” is not Literally Replacement Cost

schI get a lot of questions – and yes, some criticism – of my support for measurement of assets and liabilities at “replacement cost” (with comparative periods adjusted for the effects of inflation). My views are derived in large part from three conclusions. First, replacement cost measures are the only possible way for accounting to reflect wealth invested by shareholders in an enterprise; and consequently, changes in invested wealth. In a post and working paper that are already more than four years old, I demonstrated the truth of this proposition using a simple example.

The second conclusion is derived from the first: namely, that principles-based accounting must be primarily concerned with measurement of wealth and changes in wealth. I can think of no other principle that is more fundamental to accounting – and no way to be faithful to that principle without replacement costs. Financial reporting under complex and inconsistent rules, without principles to bind them, has been a losing proposition.

Third, I go back to the maxim that accounting affects decision making; or, “what gets measured gets done.” If management is supposed to maximize wealth, then accounting must endeavor to measure the effects of management decisions on wealth. I have tried to say this in different ways over the years, but Walter Schuetze nailed it for me this weekend over lunch in San Antonio:

“Accounting cannot stop management from doing dumb things. But, we can report it as soon as possible so the world can see the results.”

The FASB has succeeded in ignoring this self-evident maxim throughout its entire history. In doing so, it has enabled a national tragedy at many levels: obscene levels of compensation awarded to management, impairment of U.S. competitiveness, mass disruptions of financial markets, shareholder value destruction – not to mention the chaos and misery inflicted on honest, hardworking and capable individuals.

“Replacement Cost” in the Real World

However, I don’t deny that there are a lot of implementation issues that should be addressed. Perhaps the most persistent and fundamental criticism of replacement cost measures is the lack of relevance when there is little or no prospect that the existing assets will be replaced with identical, or even similar, assets. A commonly invoked scenario is when an existing asset lacks some of the desirable characteristics of later versions that are available to be purchased – say, an aging airliner.

The conceptualization of “replacement cost” that I advocate can handle this situation simply and reasonably. To begin, let’s set aside the airliner for a moment and consider inventory held for sale. For such assets, there is already a replacement-cost-based accounting treatment in U.S. GAAP (though not in IFRS), which has stood without challenge for more than 60 years.

Every accounting major will be familiar with U.S. GAAP measurement of inventories at its lower of cost or “market.” For the sake of compactness, but without loss of generality, here is the essence of the protocol:

“A departure from the cost basis of pricing the inventory is required when the utility of the goods is no longer as great as their cost … the difference shall be recognized as a loss of the current period.

… [market] provides a practical means of measuring utility.

As a general guide, utility is indicated primarily by the current cost of replacement of the goods as they would be obtained by purchase or reproduction. … [However] … replacement or reproduction prices would not be appropriate as a measure of utility when the estimated sales value, reduced by the costs of completion and disposal, is lower, in which case the realizable value so determined more appropriately measures utility.” [Accounting Standards Codification 330-10-35-1 through 4 (emphasis supplied)]

In essence, a measure of the utility of inventory (i.e., wealth invested) should be capped by the amount it could be sold for, less incremental costs of disposal. This is because it is hard to imagine a situation where replacement would be economically justified if, once replaced, the inventory could not be sold for more than its replacement cost.

Having established the concept in existing US GAAP, let’s turn back to the problem of the aging airplane. Following similar logic as for inventory, the owner should first determine whether there is an active market for airplanes of similar vintage and features. If so, then the replacement cost can be objectively based on recent transactions. But if there is no active market, then my operationalization of “replacement cost” would cap the reported amount at what could be received from sale (under current conditions), less estimated out-of-pocket costs.

Thus, there is no need to determine whether inventory is “obsolete”, or even how management intends to use and/or dispose of the asset. Moreover, the resulting measure of “market,” “current cost,” “replacement cost,” or whatever it may be called happens to be conservative because it is likely that the utility of the investment to shareholder interests is greater. This logic is buttressed by the fact that the airplane is still owned as of the balance sheet date, providing some indication that greater utility was expected from use rather than sale.

Simple Solutions to Contentious Problems of the Day

I know we are a long way from applying replacement cost or market to airplanes, but I want to conclude by pointing out that the concept of replacement cost provides for very different solutions to a number of current controversial accounting topics. Below are two very different examples.

Leases – Speaking of airplanes, many operators access them via non-transferable leases. When the right to use an asset is not transferable, “fair value” (i.e., exit price) makes no sense whatsoever; and neither does the crude and arbitrary calculations for leased assets and liabilities that the FASB and IASB are currently proposing.

The only relevant measurement attribute of non-transferable rights and obligations arising from lease contracts is replacement cost. In fact, if you believe that non-transferable rights should be recognized as assets, I can think of no better example to show why replacement cost is preferable to fair value as a comprehensive basis of measurement.

Going concern evaluations – Just yesterday, after years of rumination, the FASB announced that it has decided it will not issue a standard that would require management to disclose its going concern evaluation (instead of auditors), even though IFRS requires it of management. If all assets and liabilities were measured under the concept of replacement cost that I have described here, this would be a non issue.

A Practical Way Forward

Although I am for comprehensive use of “replacement cost” measurements, I don’t want to be seen as rigidly ideological. As the forgoing example illustrates, there are plenty of ways to significantly improve GAAP without full adoption of replacement cost measurements. By far, the most important are those inflation adjustments I mentioned in passing at the top of this posting.

In that regard, I’ll leave you with two closing thoughts: (1) a bank has not earned a profit on a loan of $10,000 when it collects a total of $10,001 over the five-year term; and (2) inflation-adjusted historic costs do a pretty good job of surrogating for actual replacement costs in most circumstances.

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