Stock and Work in Progress: The Case for Valuation at Replacement Cost - Essay Example

"Stock and Work in Progress: The Case for Valuation at Replacement Cost" The use of replacement cost in most organisations is an evident trend. From the traditional approaches, several companies have recognised the advantage of valuing assets based on value and not only cost. Replacement cost has become an integral part of the accounting system used in most firms. Indeed, use of replacement cost is attributed to its advantages. Accordingly replacement cost boosts the value of the stock and provides accurate figures. Moreover, replacement cost is capable of being used in the event of inflation which normally increases of stock price. Aside from the advantages, critics have point out that replacement cost is pure based on estimates. This contention questions the approach of replacement cost in determining exact value. Despite of these claims, replacement cost has been regarded as a viable tool the valuation of stocks and to improve the decision-making process. The framers of the method continue to develop the approach to close its loophole and ensure that using the method will provide the best results. Introduction The changes in accounting methods and principles have created several approaches to stock valuation. Traditional methods such as historical cost have remained a prominent approached used in most firms. On the other hand, emerging methods such replacement cost has gradually been adapted in some organisations. Valuation of stocks is important because it can improve the financial health of firms. The manner in which stocks are valuated affect the figures arrived when the financial statements are presented. Misappropriation of stock value will result to losses and can affect the confidence of stakeholders on the company. Logically, there are strategies used by firms to determine the best option in relation to stock valuation. It is observed that firms prefer specific valuation scheme depending on the given circumstances. Gradually, replacement cost replaces historical cost as the primary choice of valuation method. Despite the criticisms, replacement cost is considered as viable and provides firms with several advantages. This contention will be presented in the succeeding discussion along with the pertaining arguments that support the earlier claim including various criticisms. The Concept of Replacement Cost The concept of replacement cost is extensively discussed in different areas of knowledge. In accounting, however, replacement cost is defined as the cost of replacing an asset in two methods: first, through the assets' physical form; second, through the cost of acquiring similar services. The assumption in this costing method reveals that the first method has to have higher value than the second method for the asset to be obtained by the company (Hussey, 1999). Usually, replacement cost is used in assets that are considered as fixed. Eventually, the method has been preferred in assets that are circulating such as the stocks. According to Rorem (1929), replacement cost is a fundamental value that properly appraises business capital and income. Technically, the replacement cost of a stock is the expenditure required to acquire stock of similar nature and with equal economic value. When applied to stocks, replacement cost is the price of the commodity with similar kind and sales value. Replacements cost is observed to equal the prevailing purchase price and when applied in conventional mercantile principle less that the sales price. Normally, replacement cost exceeds or is valued lower that the original cost of stock. The cost rule provides important views on the manner in which replacement cost is used when the quantity is less than the original cost. The approaches to the replacement cost vary according to the kind of stock in the inventory. First, general replacement cost approach considers then entirety of the stock value as it is replaced. For instance, there are stocks produced homogenously, wherein the partly are unlikely replaced. When the commodity is replaced, the company has to produce the whole product instead of replacing some of the commodity's parts. Using the other concept of the replacement cost, the company can replace the good base on its whole value. Specific replacement cost, however, is more complicated and demands better understanding. This approach is usually applicable among stocks that are built with components and the parts can be detached without affecting the other components. Replacing the stock in this situation can mean that only a part will be changed. Instead of appraising the value of the stock, the company will only determine the value of the part. The replacement cost in this instance it differently valued because the value of the component is cheaper than the whole product that is replaced (Ireland, 1999). Given these two approaches, analysts will definitely examine which of two approaches provide the best results. Aside from the nature of the products, environmental circumstance play critical role in determining the logical approach. Basically, there are several stressors that can change the expected outcomes. Indeed, it is highly imperative to make critical analysis before arriving at a decision. Situational Analysis The use of replacement cost is mentioned in the notes to financial statements. Most firms prefer detailing the method in which stocks are valued. Aside from the fact that such process is a requirement, it provides accurate inputs in appraising the income. The use of replacement cost is evident in the recording of stocks. Instead of the traditional approach which involves historical cost, companies contend that using replacement cost adds flexibility to the valuation of cost. Such attribute is important given the uncertainties in the markets and industries. Conventionally, the historical cost of stock represents the value equivalent to the price of acquisition. For example, a retail company purchases a commodity and the value recorded is equivalent to the cost of purchase. This means that when a company buys a good for 5, the same amount will be reflected in the records. In contrast, historical cost is approached differently considering the value of the commodity. Basically, the main difference between the two methods is that the recorded value is the prevailing amount of the commodity in the market. The price of the good in the market is at 6 and this value indicates the replacement cost. This is higher than the historical cost that was discussed earlier. For companies, the cost of stock acquisition will determine the extent of mark-up to be added to the cost. Moreover, the acquisition cost will provide a perspective as to the manner in which the product will be distributed in stores. It is important that the costing method assumes all necessary aspects. Accurate management of acquisition cost determines the value that the company gains from the stocks Using replacement cost appears to be logical because it represents the value that the company expects to yield. The historical cost is static and is inflexible for adjustments. Most companies consider historical cost with the assumption that prices will change insignificantly. Also, companies are confident that sudden shifts in prices will not be a burden as consumer will shoulder the increase. Historical costs are less complicated and has causes no major modifications on financial statements. The company appears to be better-off when using replacement cost. Considering that goods are for retail, the value of the stocks will vary. At one point the acquisition cost is higher than the market value and there are also periods when the market value is lower than the acquisition cost. With these changing prices, it is imperative to use a system that can freely determine cost. Being confined to a single value will eliminate the possibilities of determining performance beyond sales. Another way to determine the usefulness of replacement cost is when inflation occurs. In economics, inflation is characterised by the spiral increase in prices of commodities. The increase in price will definitely impact the valuation of stocks. In using the historical method, the acquisition of the stocks will be valued according to the initial price of purchase. Replacement cost, however, considers the inflation as an additional value to the stocks. The recorded cost then reflects the value of the stock in the market with the percentage increase in price. Since inflation increase market prices, such change needs to be reflected in the valuation. In this manner, the cost is accurately determined and adjustments are made with precision. To further explain this circumstance, it is important to provide some helpful illustration. When a company uses historical costing the next purchase of stocks will be valued based on the cost used in the previous purchase. Indeed, the initial purchase of 5 will be reflected in all the other purchases. The occurrence of inflation will be detrimental when the historical method is used. Basically, inflation will increase the value of the purchase and will affect the profit of the company after the cost is deducted from the revenues. On the other hand, replacement cost considers the inflation as soon as it is reflected in the market price. Although the change in the value of the stock is an approximation, it will definitely be in equity with the market price. For example, the value of the stock in the market is 6 during the purchase; when the stocks were replaced, inflation has also started to manifest. In this situation, a certain value is assumed to be the possible change in amount. The cost of 6 will be replaced to accurately determine the correct price attributed to the stocks. Advantages of Replacement Cost Users of replacement cost contend that the method determines the economic value of the stock. Usually, acquisition costs are raw and are not subjected to the influence of several economic indicators. Market cost, in contrast has been adjusted and affected by the different aspects that mould economies. Aside from the actual value of the stock, replacement cost ascertains the economic implications of the purchase as well as the value of the purchase in the economy. Replacement cost is primarily designed to focus on the value of the stock. Although valuation is also cost allocation, there are certain changes that need to be manifested. Analysts have to understand that there are values in the stocks that go beyond cost. As the stocks are kept and distributed, the value of the stocks tends to increase. Historical cost has failed to determine that value and concentrated more on the allocation of cost. This particular flaw has made replacement costing more important in seeking for stock value. Moreover, replacement cost significantly focuses on the benefits provided by the assets and not just the mere value. This notion can further be explained by implying that replacement costs concentrate on the value of stock when acquired; whereas, historical costs is interested with the cost of the stocks. In truth, the value is highly important than the cost. The cost only reflects one side of the equation while the value holistically pictures the benefits provided by the stocks to the company. Finally, replacement cost provides accurate valuation of stocks during inflation. The problem with historical costing is that it assumes the same cost for a given period. In the real world, such assumption is inapplicable and provides adverse effects to financial performance. Replacement cost considers the impact of inflation and reflects the change in price to the value of the stocks as determined by analysts. Drawbacks of Replacement Cost Critics cited that replacement cost is purely made out of estimation. This is contrary to the scheme's aim of accurate and precise valuation. Essentially, the manner in which replacement cost is manifested requires predictions. Such practise will definitely affect the way stocks are valued because the assets needs to be appraised specifically. It has also been argued that estimations can affect the actual figures obtained because there will be different values for a single kind of asset. For financial analysts, simple accounting methods are valued because such principles promote efficiency. Unlike historical cost, replacement cost is complicated. Instead of determining the value of purchase, analysts have to extract the value of the stock. Usually, stocks have different values depending on their nature and benefit provided. In addition, the financial reporting is also affected because the values are based from the market. Conclusion The development of accounting principles and approaches continue to affect firm performance. Among firms that have stocks, valuation is fundamental tool that helps in gaining the most out of the stocks. The traditional methods still apply and extensively used. Methods such as replacement cost, however, have become primary options to most companies. Indeed, there is no denying that the replacement cost approach is beneficial to be used in stock valuation. Even though there are criticisms, the approach continues to be valued and used. Undeniably, most companies are starting to realise that the value of the stock is more important than the cost. Replacement cost was successful in depicting the mentioned notion. References Hussey, R., A Dictionary of Accounting, (Oxford: Oxford University Press, 1999). Ireland, T., "Opportunity cost versus replacement cost in a lost service analysis", Journal of Forensic Economics, 1999. Rorem, C.R., "Replacement cost in accounting valuation", Accounting Review, Vol. 4, No. 3, 1929, p. 167. Read More