Accounting (0452) | Accounting policies

👋 Welcome to Accounting Policies: Your Business Rulebook!

Hello IGCSE accountants! You've already learned about the fundamental Accounting Principles (like Matching and Prudence). Now, we move on to Accounting Policies.

Think of principles as the big, universal laws of accounting (like gravity). Policies are the specific, detailed rules or "recipes" a business chooses to follow within those laws (like choosing whether to bake a cake or make a sandwich).

Understanding policies is crucial because they explain how a company arrives at the figures shown in its financial statements. Let's dive in!

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What Exactly are Accounting Policies?

Definition and Purpose

An Accounting Policy is a specific principle, method, or rule adopted by a business in preparing and presenting its financial statements. Since generally accepted accounting principles (like those in Section 7.1) sometimes allow for more than one way to record a transaction, a business must choose one policy and stick to it.

• Policy Choice Example 1: A business must choose a method to calculate depreciation (e.g., straight line or reducing balance).
• Policy Choice Example 2: A business must choose how to value its inventory (e.g., lower of cost and net realisable value).

Don't worry if this seems tricky at first—the key idea is that policies are the specific choices a company makes to translate real-world transactions into figures on the balance sheet and income statement.

Key Takeaway

Accounting Policies are the detailed, specific rules and methods a business uses when there are different options available under the general accounting principles.

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The Influence of International Accounting Standards

Imagine if every country had completely different rules for preparing accounts. It would be impossible for international investors to compare businesses!

To solve this, international bodies have developed guidelines.

What are International Accounting Standards (IAS/IFRS)?

International Accounting Standards (IAS) or the newer International Financial Reporting Standards (IFRS) are globally accepted guidelines for how financial statements should be prepared.

• Why they exist: They provide a common language for accounting across the world, making it easier to understand and compare businesses internationally.
• Influence on Policies: When a business selects an accounting policy (e.g., how to treat research costs), it must choose a method that is permitted and guided by these international standards. These standards narrow down the choices available to companies, encouraging uniformity and quality.

Did you know? Over 140 jurisdictions around the world use IFRS to help standardize their accounting practices.

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Selecting Accounting Policies: The Four Objectives

When a business decides which specific policy to adopt (e.g., deciding on the depreciation method), it must ensure that the chosen policy helps its financial statements meet four fundamental objectives.

These objectives ensure the final financial statements are useful and trustworthy for everyone using them.

💡 Memory Tip: Remember the four objectives using the mnemonic C-R-R-U (Comparability, Relevance, Reliability, Understandability).

1. Comparability

Objective: Financial statements should allow users to compare the performance and position of the business:

1. Over time: Comparing the business's results this year against last year.
2. With other businesses: Comparing this business's results against a competitor's results.

If a company changes its policies every year (e.g., using straight-line depreciation one year and reducing balance the next), the resulting profit figures would be incomparable, making trend analysis impossible.

• Policy Connection: This objective links closely with the principle of Consistency. A good accounting policy must be consistently applied from one period to the next.
• Example: If Alpha Ltd uses the same depreciation policy for five years, an investor can clearly see if Alpha's profits are truly growing or shrinking.

2. Relevance

Objective: The information provided by the chosen policy must be relevant to the needs of the users (owners, managers, banks) in making economic decisions.

To be relevant, the information must be capable of making a difference to the decisions users make.

• Policy Connection: Relevant information often relates to the principle of Materiality. If a transaction is so small it wouldn't change a user's decision, the policy might be simpler (or the information might be ignored).
• Example: If a policy leads to an asset being valued at $10,000 when it’s actually worthless, that $10,000 figure is irrelevant for someone deciding whether to buy the business. The policy must aim to provide the most useful, decision-influencing figures.

3. Reliability

Objective: The financial statements must be free from material error and bias. Users need to be able to trust that the figures present a faithful representation of the business's financial health.

To achieve reliability, a policy should ensure that transactions are:

• Faithful: They truly represent the economic event.
• Neutral: Free from bias (neither deliberately overstating nor understating).
• Complete: Includes all necessary details.

Inventory Valuation Example: The standard policy is to value inventory at the lower of cost and net realisable value. This is a reliable policy because it incorporates the principle of Prudence—it ensures assets are not overstated, making the statements more trustworthy.

4. Understandability

Objective: The information must be presented clearly and concisely so that users who have a reasonable knowledge of business and accounting can understand it.

Even complex situations should be explained in a way that is easy to grasp. This is achieved through clear structure and adequate notes.

• Policy Connection: An accounting policy should not deliberately use overly complicated methods if a simpler method yields an equally reliable and relevant result, as complexity reduces understandability.
• Example: Presenting all current assets together and all non-current assets separately makes the Statement of Financial Position understandable.

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Quick Review: Why Are These Objectives Important?

Choosing the right accounting policies ensures that a business’s financial statements are useful, credible, and informative. If the policies are poorly chosen, the statements will mislead users, leading to bad decisions.