Accounting — Accounting Policies
Learning Outcomes
- Understand the meaning of 'Accounting Policies'.
- Familiarize with the situations under which selection from different accounting policies is required.
- Grasp the conditions where change in accounting policy can be made and the consequences arising from such change.
5.1 Meaning of Accounting Policies
- Accounting Policies refer to specific accounting principles and methods of applying these principles adopted by the enterprise in the preparation and presentation of financial statements.
- Policies are based on various accounting concepts, principles and conventions that have already been explained in Unit 2 of Chapter 1.
- There is no single list of accounting policies, which are applicable to all enterprises in all circumstances.
- Enterprises operate in diverse and complex environmental situations and so they have to adopt various policies.
- The choice of specific accounting policy appropriate to the specific circumstances in which the enterprise is operating, calls for considerate judgement by the management.
KNOWLEDGE NUGGET
- Accounting Policies: Specific principles and methods adopted for preparation of financial statements
- No Single List: Different policies for different enterprises and circumstances
- Management Judgement: Required for appropriate selection of policies
- ICAI reduces acceptable policies through Guidance Notes and Accounting Standards
- ICAI has been trying to reduce the number of acceptable accounting policies through Guidance Notes and Accounting Standards in its combined efforts with the government, other regulatory agencies and progressive managements.
Areas Where Different Accounting Policies are Frequently Encountered
- (1) Valuation of Inventories
- (2) Valuation of Investments
EXAMPLE — ACCOUNTING POLICY
Suppose an enterprise holds some investments in the form of shares of a company at the end of an accounting period. For valuation of shares, the enterprise may adopt FIFO, average method etc. The method selected by that enterprise for valuation is called an accounting policy.
Note: This list should not be taken as exhaustive but is only illustrative. As the course will progress, students will see the intricacies of the various accounting policies.
5.2 Selection of Accounting Policies
- Choice of accounting policy is an important policy decision which affects the performance measurement as well as financial position of the business entity.
- Selection of inappropriate accounting policy may lead to understatement or overstatement of performance and financial position.
- Thus, accounting policy should be selected with due care after considering its effect on the financial performance of the business enterprise from the angle of various users of accounts.
- It is believed that no unified and exhaustive list of accounting policies can be suggested which has universal application.
THREE MAJOR CHARACTERISTICS FOR SELECTION OF ACCOUNTING POLICIES
- Prudence — Inclusion of a degree of caution in exercise of judgments
- Substance over Form — Transactions accounted for in accordance with economic reality
- Materiality — Information is material if its misstatement could influence economic decisions
- The financial statements should be prepared on the basis of such accounting policies, which exhibit true and fair view of state of affairs of Balance Sheet and the Profit & Loss Account.
Examples of Selection from a Set of Accounting Policies
- 1. Inventories are valued at cost except for finished goods and by-products. Finished goods are valued at lower of cost or market value and by-products are valued at net realizable value.
- 2. Investments (long term) are valued at their acquisition cost. Provision for permanent diminution in value has been made wherever necessary.
IMPORTANT NOTE
Sometimes a wrong or inappropriate treatment is adopted for items in Balance Sheet, or Profit & Loss Account, or other statement. Disclosure of the treatment adopted is necessary in any case, but disclosure cannot rectify a wrong or inappropriate treatment.
5.3 Change in Accounting Policies
A change in accounting policies should be made in the following conditions:
- (a) It is required by some statute or for compliance with an Accounting Standard.
- (b) Change would result in more appropriate presentation of financial statement.
CHANGE IN ACCOUNTING POLICY — EFFECT ON FINANCIAL STATEMENTS
- Change in accounting policy may have a material effect on the items of financial statements.
- Example: If cost formula used for inventory valuation is changed from weighted average to FIFO, or if interest is capitalized which was earlier not in practice, or if proportionate amount of interest is charged to inventory which was earlier not the practice.
- Such changes may increase or decrease the net profit.
- Unless the effect of such change in accounting policy is quantified, the financial statements may not help the users of accounts.
- Therefore, it is necessary to quantify the effect of change on financial statement items like assets, liabilities, profit/loss.
EXAMPLE — CHANGE IN ACCOUNTING POLICY
Omega Enterprises revised its accounting policy relating to valuation of inventories to include applicable production overheads. It intends to do as it believes that such change would result in a more appropriate presentation of its financial statements.
Summary
- Accounting Policies refer to specific accounting principles and methods of applying these principles adopted by the enterprise in the preparation and presentation of financial statements. Policies are based on various accounting concepts, principles and conventions.
- Three major characteristics which should be considered for the purpose of selection and application of accounting policies: Prudence, Substance over form, and Materiality.
- A change in accounting policies should be made in the following conditions:
- (a) It is required by some statute or for compliance with an Accounting Standard.
- (b) Change would result in more appropriate presentation of financial statement.
Test Your Knowledge
True and False
- 1. There is a single list of accounting policies, which are applicable to all enterprises in all circumstances. False
- 2. Selection of accounting policy doesn't impact financial performance and financial position of the business. False
- 3. A change in accounting policies should be made as and when business like to show result as per their choice. False
- 4. Choosing FIFO or weighted average method for inventory valuation is selection of accounting policy. True
- 5. Selection of an inappropriate accounting policy decision will overstate the performance and financial position of a business entity every time. False
Multiple Choice Questions
| 1. A change in accounting policy is justified | (a) To comply with accounting standard and law. (b) To ensure more appropriate presentation of the financial statement of the enterprise. (c) Both (a) and (b). |
| 2. Accounting policy for inventories of Xeta Enterprises states that inventories are valued at the lower of cost determined on weighted average basis or net realizable value. Which accounting principle is followed in adopting the above policy? | (a) Materiality. (b) Prudence. (c) Substance over form. |
| 3. The areas wherein different accounting policies can be adopted are | (a) Providing depreciation. (b) Valuation of inventories. (c) Both the option. |
| 4. Selection of an inappropriate accounting policy decision may | (a) Overstate the performance and financial position of a business entity. (b) Understate/overstate the performance and financial position of a business entity. (c) Overstate the performance of a business entity. |
| 5. Accounting policies refer to specific accounting | (a) Principles. (b) Methods of applying those principles. (c) Both (a) and (b). |
High-Yield Interactive Quiz — Accounting Policies
Q1. Accounting Policies refer to:
Correct Answer: C. Accounting Policies refer to specific accounting principles and methods of applying these principles adopted by the enterprise in the preparation and presentation of financial statements.
Q2. There is a single list of accounting policies applicable to all enterprises in all circumstances.
Correct Answer: B. There is no single list of accounting policies applicable to all enterprises in all circumstances. Enterprises operate in diverse situations and have to adopt various policies.
Q3. Which of the following is an area where different accounting policies are frequently encountered?
Correct Answer: C. The areas wherein different accounting policies are frequently encountered include Valuation of Inventories and Valuation of Investments.
Q4. Which of the following is NOT a major characteristic for selection of accounting policies?
Correct Answer: D. The three major characteristics for selection of accounting policies are Prudence, Substance over Form, and Materiality.
Q5. A change in accounting policy is justified when:
Correct Answer: D. A change in accounting policy should be made when required by statute or for compliance with an Accounting Standard, or when it would result in more appropriate presentation of financial statements.
Q6. Selection of an inappropriate accounting policy may lead to:
Correct Answer: C. Selection of inappropriate accounting policy may lead to understatement or overstatement of performance and financial position.
Q7. If cost formula used for inventory valuation is changed from weighted average to FIFO, this is an example of:
Correct Answer: B. Changing the cost formula used for inventory valuation from weighted average to FIFO is a change in accounting policy.
Q8. The effect of a change in accounting policy should be:
Correct Answer: C. It is necessary to quantify the effect of change on financial statement items like assets, liabilities, profit/loss. Unless the effect is quantified, the financial statements may not help the users.
Q9. Which accounting principle is followed when inventories are valued at lower of cost or net realizable value?
Correct Answer: C. Valuation of inventories at lower of cost or net realizable value follows the principle of Prudence (conservatism).
Q10. Disclosure of a wrong treatment in financial statements:
Correct Answer: B. Disclosure of treatment adopted is necessary, but disclosure cannot rectify a wrong or inappropriate treatment.