Question

1*differences between inventory valuation systems under the IFRS system and the current system based on GAAP principles (using FASB coding).

2*Using the FASB coding system as reference, describe the benefits and weaknesses of requiring estimates for bad debts.
As part of your explanation, discuss alternative methods for accounting for bad debts.Are they appropriate? Why is one preferred over the other?

Answer 1

Question No.1 : Differences between Inventory valuation under IFRS and system based on GAAP principles

Answer: The major differences exist in areas of Accountability of costs, Inventory Valuation, Inventory reversal write down.

Accountability of costs: Generally there are three methods for inventory accountability of costs. They are weighted average cost, First in first out (FIFO) and Last in first out(LIFO). Enterprises following GAAP are allowed to follow any of the three methods whereas IFRS strictly prohibits the usage of LIFO method.

Inventory Valuation:

Under GAAP, valuation of inventory is done at cost or market value whichever is less. Market value is defned as current replacement cost.

Under IFRS, valuation of inventory is done at cost or net realisable value whichever is less. Net realisable value is estimated selling price less all costs associated with the sale.

Inventory Reversal Write downs:

In both systems inventory need to be written off as and when net realisable value falls below its cost. But the point of difference lies in reversal of such written off value.

Under IFRS, reversal of written off amounts are allowed and to be recognised in financial statements.

Under GAAP, Such reversals are altogether prohibited.

Question 2: Benefits and weaknesses of requiring estimates for bad debts

Firstly, the requirement of estimating bad debts is to adhere to the matching principle.

Benefits:

1. It reduces net income therby having a savings in tax if it is allowable bad debt.

2. It matches the revenue earned or accrued from credit sales with the expense incurred from them.

Weaknesses:

1. Estimations are generally based on credibility of debtors and if in a case the debtor whom we estimate as more credible might actually go insolvent and vice versa. So it is a subjective concept which is an inherent weakness.

2. Economic conditions may have a huge impact. Examples are:

a) Bad debts in China have risen have risen almost 18 quarters resulting in economy slow down.

b) In 2015, UK banks and building societies wrote off euro 3.175 billion of loans to individuals.

Methods for accounting for bad debts:

1. Direct write off method: Companies use this method when they decide that no portion of debt can be realised from the customer. They should use all the reasonable ways to clooect money.

Pros:

a) Very easy to use.

b) Bad Debts can be written off by the companies on their annual tax returns.

Cons:

a) There exists a possibility of expense manipulation due the reason that companies record expenses and revenue in different time periods.

b) Only useful for small amounts that doesn't have financial impact.

2. Allowance method: Companies dont immediately write off instead they estimate bad debts based on past data available. Firstly it transfers to an account called allowance for doubtful debts and only when they feel that nothing or a part is never recoverable then such amount is transferred to profit or loss account.

Pros:

a) Folllows matching principle which result in accurate financial records.

b) Balance sheet accurately reports debtors which benefits the users of financial information.

Cons:

a) Inaccurate estimation may lead to major differences in projection of companies performance to the outsiders.

Conclusion: Direct write off method is not allowed under GAAP because it does not follow matching principle. Allowance method is used widely used because accounts receivable are shown after adjusting the allowance created and thus shows most accurate amount that can be actuall collected. But in direct write off method bad debt expense in prior period is deducted from unrelated income i.e., the current year profits. So the Allowance method is preferred over the Direct Write Off method.

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