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1 January 1982 Financial Analysts Journal Volume 38, Issue 1

Operating Income and Distributable Income under Replacement Cost Accounting: The Long-Life Asset Replacement Problem

  1. Donald R. Nichols

Advocates of replacement cost accounting are divided between the goal of separating income into components of “operating income” and “holding gains and losses” and the goal of measuring “distributable income.” Distributable income may be defined as the amount of earnings a firm can distribute to owners while maintaining the current level and mode of operations indefinitely at current prices. Operating income is usually defined as “revenues conventionally measured less cost of goods sold and depreciation based on current replacement costs.”

When assets have short lives, or when the prices of long-lived assets do not change over their useful lives, distributable income will equal operating income. However, when the firm owns assets with long lives, and when the prices of those assets change over their lives, replacement cost accounting will tend to underestimate depreciation; this is the “long-life asset replacement,” or LAR, problem. It results in “income” as measured being overstated from a distributable income perspective.

Vancil and Weil have suggested a solution to the LAR problem that involves viewing the cash retained by the firm each year (assuming the “income” amount is distributed) as a “replacement fund” that is invested to earn a return. If the earnings rate on the retained amount equals the rate of change in the price of the asset being depreciated, the total funds accumulated at the end of the asset’s life will equal the replacement cost of the asset, and “income” as measured will equal distributable income. If the earnings rate on the retained amount exceeds the rate of price change of the asset, the “excess earnings of the replacement fund” will be included in income; if the fund earns at an amount less than the rate of price increase in the asset, the fund’s earnings will not be included in income.

A better approach would be to view “income” as measured as operating income. Any earnings from retained funds would be added to operating income, and any shortfalls due to underdepreciation would be subtracted as “depreciation catch-up,” to arrive at the distributable amount. This approach treats the earnings on reinvested funds consistently—as an element of revenue and income. Also, since it reports both operating and distributable income, it may provide a potential basis for reconciling the operating income and distributable income views.

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