IAS 16 Property, Plant and Equipment (IAS 16) recognizes the fact that fair value of every asset may not be determined using market value basis. Although it is recommended and hardly the case where market information does not help but still exceptions exist. IAS 16 recognises such assets specialized assets for which fair value cannot be measured on market value basis.
For such specialized assets IAS 16 allows two alternative treatments:
- Depreciated replacement cost approach (also known as DRC among accountants)
- Income approach
Depreciated replacement cost is derived from replacement cost where replacement cost is simply the cost entity has to incur to replace current asset with such asset that can generate similar cash flows or provide same benefits. Usually current price of similar asset provides reasonable basis to estimate replacement value however, replacement cost does not necessarily equate market price of the asset.
Once replacement cost is established it will be reduced by accumulated depreciation where depreciation is calculated on the same basis as used for original asset or whatever basis deem fit for valuation purposes.
Income approach on the other measures the fair value on the basis of present value of future economic benefits arising from the use of such asset. This approach accounts for future cash flows expected from such asset and then discounting such future inflows to present date to provide basis for fair value measurement. To learn more about income approach read: What is Income approach to fixed asset revaluation?
Which of the above two approaches is better depends on the circumstances. In some situations DRC provides better basis whereas in other cases income approach provides quality information. However, as both of these two estimation are alternate to market value basis therefore they need to stay consistent with market value approach to determine fair value of the asset.
However, one strong argument in favour of depreciated replacement cost (DRC) is that it helps us value the asset on the basis of cost entity is willing to pay for the same benefits they are having with currently employed asset and nothing more than that. So benefits are relative to cost and consideration of benefits depends on at what cost such benefits are collected therefore, DRC is more relevant logically as income approach only considers the future cash flows. But again its just the difference in the perspective which hopefully will reduce over a period of time as these approaches develop.