Page 85 - DCOM409_CONTEMPORARY_ACCOUNTING

Contemporary Accounting

Notes
Did u know? What is replacement cost?

Replacement cost occurs only at the moment of replacing the resources which is mainly
based on the current value approach.
The approach is similar to the historical cost approach mentioned above except that it allows for
changes in the cost for acquiring, training and developing the employees in place of taking their
historical cost for capitalisation.

Merits of Replacement Cost Approach

The method has the following merits:

The approach incorporates the current value of the firm’s human resources. Thus, the
financial statements prepared according to this approach are more realistic as compared
to those prepared under historical cost approach.
The method is more representative and logical.

Limitations of Replacement Cost Approach

The method has the following limitations:
The method is at variance with conventional accounting practice of valuing assets at
historical costs.
It is almost impossible to ascertain correct replacement cost of existing human resources
since there can be no complete replacement for them.

There is no objective way for determination of replacement cost. Personal prejudices do
work. Moreover, there is no foolproof method for verification of replacement cost.

7.1.3 Opportunity Cost Approach

This approach has been suggested by Hekimian and Jones. According to this approach, the value
of an employee is determined according to his alternative use. In case an employee has no
alternative use, no value will be placed on him. This approach specifically excludes those types
of employees who can be hired readily from outside. The approach suggests competitive bidding
process for the scarce employees in an organisation. It means that the opportunity cost is linked
with scarcity. The opportunity cost of an employee or a group of employees in one department
is calculated on the basis of the offers (bids) by other departments for those employees. This will
be clear from the following example.

Example: A company has two departments X and Y. The amount of capital employed (in
physical assets) in department X and Y is `10 lakhs and ` 5 lakh respectively. The required rate
of return on total capital employed (physical as well as human) is 15%. It is projected that with
the employment of a specific group of technocrats, department X can make a profit of ` 3 lakhs
while department Y can make a profit of ` 2.5 lakhs.

The capitalised value of profit with the technocrats at the rate of 15% comes to ` 20 lakhs in case
of department X and `16.67 lakhs for department Y. In case the value of physical assets is
deducted from these figures, the value of human resources comes to ` 10 lakhs in case of
department X and `11.67 lakhs in case of department Y. Hence, department Y can offer a higher
bid for the technocrats as compared to department WIPRO.

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