Accounting Policies

THEORETICAL FRAMEWORK 1.
81
UNIT – 5 ACCOUNTING POLICIES
LEARNING OUTCOMES
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.
UNIT OVERVIEW
Selection of Accounting Policies
Based on
Prudence Substance over form Materiality
© The Institute of Chartered Accountants of India

1.82 ACCOUNTING
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.

THEORETICAL FRAMEWORK 1.83
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.

1.84 ACCOUNTING
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.

THEORETICAL FRAMEWORK 1.85
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.

1.86 ACCOUNTING
1.86
4. True: An enterprise may adopt FIFO or weighted average method for inventory
valuation and the method selected for valuation is called an accounting policy.
5. False: It could understate/overstate the performance and financial position of a

business entity.
Multiple Choice Questions
1. (c) 2. (b) 3. (b) 4. (b) 5. (c)

7. (c) 8. (a) 9 (c)
Theoretical Questions
1. 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. For details, refer para 5.1.
2. 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. Unless the effect of such change in accounting policy is
quantified, the financial statements may not help the users of accounts.

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THEORETICAL FRAMEWORK 1.

UNIT – 5 ACCOUNTING POLICIES

After studying this Unit, you will be able to:

Selection of Accounting Policies

Prudence Substance over form Materiality

© The Institute of Chartered Accountants of India

5.1 MEANING OF ACCOUNTING POLICIES

5.2 SELECTION OF ACCOUNTING POLICIES

© The Institute of Chartered Accountants of India

5.3 CHANGE IN ACCOUNTING POLICIES

(b) Change would result in more appropriate presentation of financial statement

© The Institute of Chartered Accountants of India

♦ A change in accounting policies should be made in the following conditions:

(b) Change would result in more appropriate presentation of financial statement.

TEST YOUR KNOWLEDGE

4. Choosing FIFO or weighted average method for inventory valuation is selection of

Multiple Choice Questions

1. A change in accounting policy is justified

© The Institute of Chartered Accountants of India

3. The areas wherein different accounting policies can be adopted are

© The Institute of Chartered Accountants of India

5. False: It could understate/overstate the performance and financial position of a

Multiple Choice Questions

1. (c) 2. (b) 3. (b) 4. (b) 5. (c)

1. Accounting Policies refer to specific accounting principles and methods of applying

© The Institute of Chartered Accountants of India

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