ICAI Notes- Unit 5: Accounting Policies | Principles and Practice of Accounting - CA Foundation PDF Download

 Page 1


1.81
THEORETICAL FRAMEWORK 
 
LEARNING OUTCOMES 
UNIT – 5 ACCOUNTING POLICIES 
 
 
After studying this Unit, you will be able to: 
? 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. 
 
 
 
 
 
 
 
 
 
 
 
 
 
Selection of Accounting Policies
Based on
Prudence Substance over form Materiality
UNIT OVERVIEW 
© The Institute of Chartered Accountants of India
Page 2


1.81
THEORETICAL FRAMEWORK 
 
LEARNING OUTCOMES 
UNIT – 5 ACCOUNTING POLICIES 
 
 
After studying this Unit, you will be able to: 
? 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. 
 
 
 
 
 
 
 
 
 
 
 
 
 
Selection of Accounting Policies
Based on
Prudence Substance over form Materiality
UNIT OVERVIEW 
© The Institute of Chartered Accountants of India
  ACCOUNTING 
1.82 
1.82 
 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. 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. Already it has achieved some progress in this respect. 
The areas wherein different accounting policies are frequently encountered can be given as 
follows: 
(1) Valuation of  Inventories; 
(2) Valuation of  Investments. 
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. 
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.  
 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 which should be considered for the 
purpose of selection and application of accounting policies. viz., Prudence, Substance over 
form, and Materiality. 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. 
© The Institute of Chartered Accountants of India
Page 3


1.81
THEORETICAL FRAMEWORK 
 
LEARNING OUTCOMES 
UNIT – 5 ACCOUNTING POLICIES 
 
 
After studying this Unit, you will be able to: 
? 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. 
 
 
 
 
 
 
 
 
 
 
 
 
 
Selection of Accounting Policies
Based on
Prudence Substance over form Materiality
UNIT OVERVIEW 
© The Institute of Chartered Accountants of India
  ACCOUNTING 
1.82 
1.82 
 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. 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. Already it has achieved some progress in this respect. 
The areas wherein different accounting policies are frequently encountered can be given as 
follows: 
(1) Valuation of  Inventories; 
(2) Valuation of  Investments. 
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. 
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.  
 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 which should be considered for the 
purpose of selection and application of accounting policies. viz., Prudence, Substance over 
form, and Materiality. 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. 
© The Institute of Chartered Accountants of India
1.83
THEORETICAL FRAMEWORK 
 
Examples wherein selection from a set of accounting policies is made, can be given as follows:– 
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. 
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 may have a material effect on the items of financial statements. 
For 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 changed to inventory which was earlier not the practice, all these 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. 
For example, 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. viz., Prudence, Substance over form, and 
Materiality. 
© The Institute of Chartered Accountants of India
Page 4


1.81
THEORETICAL FRAMEWORK 
 
LEARNING OUTCOMES 
UNIT – 5 ACCOUNTING POLICIES 
 
 
After studying this Unit, you will be able to: 
? 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. 
 
 
 
 
 
 
 
 
 
 
 
 
 
Selection of Accounting Policies
Based on
Prudence Substance over form Materiality
UNIT OVERVIEW 
© The Institute of Chartered Accountants of India
  ACCOUNTING 
1.82 
1.82 
 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. 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. Already it has achieved some progress in this respect. 
The areas wherein different accounting policies are frequently encountered can be given as 
follows: 
(1) Valuation of  Inventories; 
(2) Valuation of  Investments. 
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. 
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.  
 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 which should be considered for the 
purpose of selection and application of accounting policies. viz., Prudence, Substance over 
form, and Materiality. 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. 
© The Institute of Chartered Accountants of India
1.83
THEORETICAL FRAMEWORK 
 
Examples wherein selection from a set of accounting policies is made, can be given as follows:– 
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. 
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 may have a material effect on the items of financial statements. 
For 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 changed to inventory which was earlier not the practice, all these 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. 
For example, 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. viz., Prudence, Substance over form, and 
Materiality. 
© The Institute of Chartered Accountants of India
  ACCOUNTING 
1.84 
1.84 
? 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. 
2. Selection of accounting policy doesn’t impact financial performance and financial 
position of the business 
3. A change in accounting policies should be made as and when business like to show result as 
per their choice. 
4. Choosing FIFO or weighted average method for inventory valuation is selection of 
accounting policy. 
5. Selection of an inappropriate accounting policy decision will overstate the performance 
and financial position of a business entity every time. 
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. 
 
 
© The Institute of Chartered Accountants of India
Page 5


1.81
THEORETICAL FRAMEWORK 
 
LEARNING OUTCOMES 
UNIT – 5 ACCOUNTING POLICIES 
 
 
After studying this Unit, you will be able to: 
? 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. 
 
 
 
 
 
 
 
 
 
 
 
 
 
Selection of Accounting Policies
Based on
Prudence Substance over form Materiality
UNIT OVERVIEW 
© The Institute of Chartered Accountants of India
  ACCOUNTING 
1.82 
1.82 
 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. 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. Already it has achieved some progress in this respect. 
The areas wherein different accounting policies are frequently encountered can be given as 
follows: 
(1) Valuation of  Inventories; 
(2) Valuation of  Investments. 
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. 
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.  
 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 which should be considered for the 
purpose of selection and application of accounting policies. viz., Prudence, Substance over 
form, and Materiality. 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. 
© The Institute of Chartered Accountants of India
1.83
THEORETICAL FRAMEWORK 
 
Examples wherein selection from a set of accounting policies is made, can be given as follows:– 
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. 
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 may have a material effect on the items of financial statements. 
For 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 changed to inventory which was earlier not the practice, all these 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. 
For example, 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. viz., Prudence, Substance over form, and 
Materiality. 
© The Institute of Chartered Accountants of India
  ACCOUNTING 
1.84 
1.84 
? 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. 
2. Selection of accounting policy doesn’t impact financial performance and financial 
position of the business 
3. A change in accounting policies should be made as and when business like to show result as 
per their choice. 
4. Choosing FIFO or weighted average method for inventory valuation is selection of 
accounting policy. 
5. Selection of an inappropriate accounting policy decision will overstate the performance 
and financial position of a business entity every time. 
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. 
 
 
© The Institute of Chartered Accountants of India
1.85
THEORETICAL FRAMEWORK 
 
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). 
Theoretical Questions 
1. Define Accounting Policies in brief. Identify few areas wherein different accounting 
policies are frequently encountered. 
2. “Change in accounting policy may have a material effect on the items of financial 
statements.” Explain the statement with the help of an example. 
ANSWERS/HINTS 
True and False 
1. False: There cannot be single list of accounting policies, which are applicable to all 
enterprises in all circumstances. There would always be different policies chosen by 
different industries under different circumstances. 
2. False: Accounting policy has big impact on value of items goes under financial 
statements, hence it impacts financial performance and financial position of the 
business. 
3. False: 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. 
© The Institute of Chartered Accountants of India