6.1 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. Different enterprises may adopt different accounting policies. Likewise, different methods of providing depreciation on fixed assets, i.e. Straight line, written down, etc. are available to the business enterprises which will lead to different depreciation amounts.
6.2 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.
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. I Inventories (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.
6.3 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 depreciation method is changed from straight-line method to written-down value method, or 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.
The examples in this regard may be given as follows:
1. Omega Enterprises revised its accounting policy relating to valuation of inventories to include applicable production overheads.
2. Alpha Enterprises changed the method of depreciation from straight-line method to written-down value method which constitutes change in accounting policy.