DEPRECIATION AND REPLACEMENT OF ASSETS

In the context of present inflationary conditions, it will be appropriate to provide for depreciation on the replacement cost instead of on the historical cost. This is because of the fact that depreciation is provided for replacing the asset. Sufficient funds will not be available for replacing an asset at the end of its serviceable life. If depreciation is provided on the basis of historical cost, there is substantial increase in the cost of the new asset to replace the old asset. But following difficulties may crop up when replacement cost system is used:

(a) Estimating replacement cost in advance is difficult.

(b) The method of charging depreciation on the basis of replacement cost is not recognized by income tax authorities.

(c) The method of charging depreciation on replacement cost during inflationary conditions is preferred but not during period of falling prices.

(d) According to the Companies Act, depreciation should be charged on the original cost of the asset and any deficiency or surplus arising due to sale of such asset should be transferred to the profit and loss account.

(e) Any new asset purchased, with few exceptions, is always of a better quality than the asset replaced. Hence, it is difficult to calculate the cost of the asset replaced.

These difficulties can be obviated by taking the following steps:

(a) The additional amount required for replacing the asset over and above the original cost of the asset may be estimated. Every year, an appropriate amount may be transferred from profit and loss account besides usual depreciation on asset to provide for additional amount required for replacement of the  asset over and above the original cost of the asset. It may be debited to Profit and Loss Appropriation Account and credited to Replacement Reserve account.

(b) The Replacement Reserve Account may be credited every year with interest at the current rate on the accumulated balance standing to the credit of the account.