Realizable Value Accounting

Both historical cost and replacement cost accounting employ entry values, that is, they are based on the acquisition cost of assets. By contrast, realizable value accounting employs exit values, that is, it is based on the realizable price of assets.

The distinction between entry and exit values leads to two different concepts of income-realized and realizable income. Realized income arises only upon sale, so that unsold assets are valued at cost. By contrast, realizable income is based on the current selling price of the assets, thereby indicating the revenue which could be obtained should the assets be sold. As a result, unsold assets are valued not at cost, but at realizable value.

The case for realizable value accounting

The realizable value model is based on the concept of opportunity cost, that is, value is expressed in terms of the benefit lost in holding assets in their present form rather than in the next best alternative form. For example, as regards closing inventories, the next best alternative to holding inventories is selling them, so that on an opportunity cost basis, the value of closing inventories is what they would realize if sold.

Chambers and Sterling have argued in favour of realizable value accounting. According to Chambers, for example, the most important characteristic of the firm is its capacity to adapt to a changing environment, and in this way, to ensure its survival. The survival of the firm depends, therefore, on its ability to acquire goods and services, which is related to the realizable value of its existing assets. Chambers coined the term 'current cash equivalent' to indicate the realizable value of the firm's currently held assets, that is, the cash represented by those assets and available, if sold, for investing in market alternatives and consequently redeploying its resources.

By contrast, replacement cost accounting reflects a relatively static situation, and does not inform investors about the economic sacrifice made in holding resources in their current form.

Another argument in favour of realizable value accounting is that realizable value income is an acceptable surrogate for economic income, for it indicates future cash flows which may result from the realization of currently held assets. As we have argued, the present value of future cash flows associated with the holding of assets is the most relevant concept of value from the point of view of investors. Backward looking concepts, such as historical cost and replacement cost values, are poor surrogates as predictors of future cash flows.

Finally, a further argument in favour of realizable value lies in its relevance to the needs of creditors for information about the market value of the assets held by a company to which they have extended credit facilities, particularly if the security for loans and other forms of credit is represented by liens or mortgages over such assets.

Components of realizable income

Realizable income reflects the periodic change in the value of enterprise capital measured in terms of resale price. It consists of two components:

(a) Realized gains resulting from the sale of assets during the accounting period, which are measured as the difference between the actual realized revenue from sale and the realizable value estimated at the beginning of the period.

(b) Unrealized gains resulting from changes in the realizable value of assets which have remained unsold at the end of the accounting period.

Realizable income

We noted in our earlier discussion of holding gains arising under replacement cost accounting that such gains could not be treated as part of replacement income. The reason for this view is to be found in the capital maintenance criterion to which replacement cost income is directed. By contrast, the realizable value concept of income is directed towards measuring the firm's ability to adapt to a changing environment, and for this purpose, income is required to measure changes in the firm's command over goods and services. This may be measured by reference to both realized gains, and unrealized gains which result, as we mentioned earlier, from changes in the realizable value of assets during the year. Hence, under realizable value income, no distinction is maintained between current operating income and holding gains. Assets are shown on the balance sheet at their realizable value.

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Read on: An Evaluation of Replacement Cost Accounting

An evaluation of replacement cost accounting

As a method of financial reporting, the objective of replacement cost accounting is to provide a concept of income which will satisfy the criteria of relevance and feasibility which were discussed earlier.

Replacement cost income is more relevant to investors than accounting income for the purpose of decision making. First, it provides for the maintenance of the service potential of capital by charging against revenue the cost of replacing the assets exhausted in earning revenue. Second, an important distinction is made between operating... see: An Evaluation of Replacement Cost Accounting