7.2 Accounting Policies: Ensuring Comparability

Accounting policies are the principles and methods a business adopts when preparing its financial statements. They are crucial for ensuring that financial information is consistent from period to period and between different businesses. This consistency is fundamental for comparability, allowing users of financial statements to make informed decisions.

Why are Accounting Policies Important for Comparability?

Without consistent accounting policies, it would be difficult to compare the financial performance and position of different companies. For example, if one company uses a different method for valuing inventory than another, it would be hard to say which company is truly more profitable.

Key Areas of Accounting Policies

Accounting policies cover a wide range of decisions. Some of the most important areas include:

• Valuation of Inventory
• Depreciation Methods
• Revenue Recognition
• Cost of Goods Sold (COGS) Calculation
• Treatment of Provisions and Contingencies
• Financial Instruments

Examples of Accounting Policies and their Impact on Comparability

Let's look at some specific examples:

1. Inventory Valuation:

   A business can choose to value its inventory using either FIFO (First-In, First-Out) or weighted average cost.

   • FIFO: Assumes the first units purchased are the first ones sold.
   • Weighted Average Cost: Calculates an average cost for all units available for sale.

   Using different methods will result in different inventory values and, consequently, different profit figures. A company consistently using one method allows for easier comparison with other companies using the same method.

2. Depreciation Methods:

   Businesses can depreciate assets using methods like straight-line, reducing balance, or units of production.

   • Straight-line: Depreciates the asset evenly over its useful life.
   • Reducing Balance: Depreciates a fixed percentage of the asset's book value each year.

   Different depreciation methods will affect the reported depreciation expense and the carrying value of assets. Consistent use of a single method is essential for comparability.

3. Revenue Recognition:

   Companies need to decide when to recognize revenue. Common methods include:

   • Accrual Basis: Revenue is recognized when earned, regardless of when cash is received.
   • Cash Basis: Revenue is recognized when cash is received.

   The choice of revenue recognition method significantly impacts reported revenue and profitability. Using the same method consistently is vital for comparability.

How to Identify Accounting Policies

Accounting policies are usually disclosed in the notes to the financial statements. Look for sections titled "Accounting Policies," "Significant Accounting Policies," or similar headings. These sections will detail the specific policies the business has adopted.

Importance for Users of Financial Statements

Understanding a company's accounting policies is crucial for users of financial statements (e.g., investors, creditors, analysts). It allows them to:

• Assess the reliability of the financial information.
• Compare the financial performance of different companies.
• Identify potential biases or inconsistencies in the financial statements.

Table: Examples of Accounting Policies and their Impact

Accounting Policy	Description	Impact on Financial Statements
Inventory Valuation	FIFO or Weighted Average Cost	Different inventory values, affecting cost of goods sold and profit.
Depreciation Method	Straight-line, Reducing Balance, or Units of Production	Different depreciation expense and carrying value of assets.
Revenue Recognition	Accrual or Cash Basis	Different timing of revenue recognition, affecting reported revenue and profit.
Provisions	When and how to recognise provisions for bad debts or other contingencies.	Impacts profit and the balance sheet.