Replacement cost refers to the cost that would be incurred to replace an asset with a similar asset in the current market, at current prices. It is the cost of acquiring or constructing an asset that would provide the same service or utility as the existing asset.

For example, if a company owns a building that was constructed many years ago, the replacement cost of the building would be the cost of constructing a new building with similar design and functionality in the current market. Similarly, if a company owns a fleet of vehicles that were purchased several years ago, the replacement cost of the fleet would be the cost of purchasing new vehicles with similar specifications in the current market.

Replacement cost is an important consideration in determining the fair value of an asset for financial reporting purposes, particularly under the market approach to valuation. It is also used as a benchmark for assessing the performance of an existing asset, by comparing its carrying value on the balance sheet to its replacement cost. If the carrying value of the asset is lower than its replacement cost, it may indicate that the asset is undervalued and may need to be revalued to reflect its current value. Conversely, if the carrying value of the asset is higher than its replacement cost, it may indicate that the asset is overvalued and may need to be impaired or written down.

Here's an example to illustrate replacement cost:

Let's say a company owns a building that was constructed 20 years ago. The building has a remaining useful life of 20 years and a current carrying value of $500,000 on the company's balance sheet. To determine the replacement cost of the building, the company obtains a quote from a contractor to construct a new building with similar design and functionality. The quote is for $1,000,000.

In this case, the replacement cost of the building is $1,000,000. This means that if the company were to replace the existing building with a new building of similar design and functionality, it would cost $1,000,000. If the carrying value of the building on the balance sheet is less than $1,000,000, it may indicate that the building is undervalued and may need to be revalued to reflect its current value.

For example, if the company were to revalue the building based on replacement cost, the journal entry would be as follows:

Building (asset) $500,000

Revaluation surplus (equity) $500,000

The building account is increased to reflect its new value of $1,000,000, and the revaluation surplus account is credited with the increase of $500,000. This increases the equity section of the balance sheet, and reflects the increase in value of the building as a result of the revaluation based on replacement cost.