Current Cost: Definition, Example, and FAQs

Current cost is an accounting valuation method that measures the present-day cost to replace an asset or service. Unlike historical cost, which records an asset at its original purchase price, current cost reflects what it would cost to acquire an identical or equivalent asset today. This approach is particularly relevant in financial reporting, aiming to provide a more accurate picture of a company's financial position, especially during periods of changing prices.

What Is Current Cost?

Current cost is the estimated amount of cash or its equivalent that would be paid if the same or an equivalent asset were acquired currently. It attempts to answer the question: "What would it cost to replace this asset right now?" This valuation method stands in contrast to the commonly used historical cost method, which records the original acquisition price of assets. By reflecting present market conditions, current cost provides a more up-to-date view of a company's financial statements and underlying economic realities.

History and Origin

The concept of current cost accounting gained prominence during periods of high inflation, particularly in the 1970s. As prices for goods and services escalated rapidly, the historical cost method often presented a misleading view of a company's true profitability and the real value of its assets. Companies found that the revenue generated from selling goods produced using older, lower-cost inventory was artificially inflated, as the cost of replacing that inventory had risen significantly.

In response to these challenges, accounting bodies, including the Financial Accounting Standards Board (FASB) in the United States, explored and sometimes mandated forms of inflation accounting, which incorporated current cost principles. While the direct mandate for comprehensive current cost accounting largely receded as inflation subsided, the underlying objective of providing relevant and representationally faithful financial information remains a core principle in accounting today. The broader objectives and fundamentals that guide financial reporting, including considerations of asset measurement, are outlined in conceptual frameworks developed by accounting standard-seters.¹⁰, ¹¹, ¹², ¹³, ¹⁴

Key Takeaways

• Current cost represents the current replacement cost of an asset or service.
• It provides a more contemporary valuation compared to historical cost, especially in inflationary environments.
• The method aims to reflect a company's true economic profitability by matching current revenues with current expenses.
• Implementing current cost accounting can be complex due to the need for frequent revaluation and subjective estimations.
• While not the primary accounting method under most current accounting standards, its principles inform various valuation techniques.

Formula and Calculation

Current cost is not typically determined by a single universal formula applied to an entire entity's balance sheet. Instead, it involves assessing the current replacement or reproduction cost for individual assets, such as inventory or property, plant, and equipment.

For a specific asset, the current cost can be thought of as:

$\text{Current Cost} = \text{Cost to acquire an identical or equivalent new asset today}$

Or, for items like inventory, it might involve:

$\text{Current Cost of Inventory} = \text{Current purchase price per unit} \times \text{Number of units}$

When adjusting for the impact of inflation on previously acquired assets, a price index can sometimes be used, although direct market quotations are generally preferred if available. For example, if the original cost of an asset was known and the general price level has changed, an estimated current cost could be:

$\text{Current Cost} = \text{Original Cost} \times \left( \frac{\text{Current Price Index}}{\text{Price Index at Acquisition}} \right)$

This calculation aims to adjust the original cost to a current purchasing power equivalent, reflecting the impact of changing prices on the asset's value. For assets subject to wear and tear, an allowance for depreciation from the current cost of a new asset would also be considered.

Interpreting the Current Cost

Interpreting current cost primarily involves understanding its implications for a company's financial health and operational decisions. When assets and liabilities are valued at their current cost, the resulting financial statements provide a more realistic assessment of the resources available to the business and the obligations it faces.

For instance, a profit and loss statement prepared under current cost principles would reflect the current cost of goods sold, rather than the historical cost, potentially leading to a more accurate depiction of sustainable earnings. Similarly, a balance sheet would show assets at their present replacement value, giving a clearer indication of the actual capital expenditures required to maintain the business's operating capacity. This perspective helps stakeholders gauge the enterprise's ability to replace its productive capacity and manage its resources in the prevailing economic environment.

Hypothetical Example

Consider a manufacturing company, "Alpha Corp," that purchased a specialized machine five years ago for $100,000. Under the historical cost method, this machine would continue to be recorded on Alpha Corp's balance sheet at its depreciated original cost.

However, suppose the cost to acquire an identical, new machine today is $150,000 due to inflation and technological advancements. If Alpha Corp were to calculate the current cost of this machine, it would consider this $150,000 figure, adjusted for any wear and tear the existing machine has experienced.

For example, if the existing machine is estimated to have a remaining useful life equivalent to 70% of a new machine, its current cost, adjusted for current condition, might be $105,000 (70% of $150,000). This provides a more realistic view of the capital needed to replace the machine and its current economic value, impacting decisions related to future capital expenditures and understanding the true cost of operations.

Practical Applications

While historical cost remains the predominant accounting basis, the principles of current cost are applied in various real-world scenarios and analyses, particularly when assessing the true economic value of assets and profitability.

• Managerial Decision-Making: Businesses use current cost concepts when making critical decisions about pricing, budgeting for asset replacement, and evaluating the profitability of product lines. Understanding the current cost of inventory and other assets helps managers set appropriate selling prices that cover current replacement costs, ensuring the sustainability of operations.
• Asset Valuation and Appraisal: Professional appraisers frequently use current cost, often referred to as "replacement cost new less depreciation," to determine the value of property, plant, and equipment for insurance purposes, mergers and acquisitions, or internal strategic planning. This method focuses on the cost to reproduce or replace a property.
• Inflation Accounting: In economies experiencing significant inflation, some entities or industries may adopt current cost adjustments to financial statements to provide a more realistic view of their financial performance and position. This helps avoid "illusory profits" that arise when historical costs are matched against current revenues.
• Economic Analysis: Economists and policy makers often look beyond traditional accounting figures to understand the true market value and economic depreciation of capital stock. Measures like the Consumer Price Index (CPI), which tracks the average change over time in the prices paid by urban consumers for goods and services, are critical tools in understanding broad price changes that influence current cost.⁵, ⁶, ⁷, ⁸, ⁹
• Comparison to Fair Value: While distinct, current cost shares conceptual similarities with fair value accounting, which values assets and liabilities at the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.², ³, ⁴ Both aim to provide a more current view of value than historical cost, and discussions around them can involve macroeconomic stability.¹

Limitations and Criticisms

Despite its theoretical appeal in reflecting current economic realities, current cost accounting faces several significant limitations and criticisms that have prevented its widespread adoption as a primary accounting method.

One major drawback is subjectivity. Determining the current cost of a specific asset can be challenging and requires considerable judgment, especially for unique or specialized items where an active market for identical replacements may not exist. This subjectivity can reduce the verifiability and comparability of financial statements across different companies or even over time for the same company.

Another criticism is the cost and complexity of implementation. Continuously revaluing all non-monetary assets and equity to their current cost basis would require substantial resources, including expert appraisals and sophisticated accounting systems. This can be particularly burdensome for smaller businesses.

Furthermore, current cost accounting can introduce volatility into reported earnings and equity balances. Fluctuations in the prices of replacement assets, driven by inflation or other market dynamics, would directly impact the profit and loss statement and balance sheet, potentially making financial performance appear less stable. This can make it harder for investors and creditors to analyze trends and make informed decisions, as large revaluation gains or losses might obscure underlying operational performance.

The primary accounting standard setters generally favor a mixed attribute model that uses historical cost for most non-financial assets and fair value for certain financial instruments, rather than a comprehensive current cost system, primarily due to concerns about objectivity, cost, and the potential for earnings volatility.

Current Cost vs. Historical Cost

The fundamental difference between current cost and historical cost lies in their valuation basis and the financial picture they present.

While current cost aims to provide a more economically relevant valuation, historical cost prioritizes reliability and verifiability. Most accounting systems today use a blend of valuation methods, but historical cost remains foundational for many assets and liabilities.

FAQs

Why isn't current cost accounting widely used today?

Current cost accounting is not widely used as a primary method due to its subjective nature, the significant cost and complexity of consistently revaluing all assets and liabilities, and the potential for increased volatility in reported financial results. Most accounting standards prioritize verifiability and objectivity, which are more readily achieved with the historical cost basis for many items.

Does current cost impact a company's taxes?

Generally, current cost accounting does not directly impact a company's taxable income. Tax regulations in most jurisdictions are based on historical cost principles, including rules for depreciation and the cost of goods sold. While internal management might use current cost for decision-making, financial statements prepared for tax purposes typically adhere to historical cost.

Is current cost always higher than historical cost?

No, current cost is not always higher than historical cost. While it often is during periods of inflation (when prices are rising), current cost could be lower than historical cost if there has been deflation (falling prices) or if technological advancements have made it cheaper to produce or acquire an equivalent new asset. The relationship depends entirely on market conditions since the asset's original acquisition.