IGCSE Accounting 0452 - 7.2 Accounting Policies

Introduction

Accounting policies are the principles and methods that an organisation uses when preparing its financial statements. They provide a framework for consistent and comparable reporting. Choosing appropriate accounting policies is crucial as they can significantly impact the reported financial performance and position of a business.

Why are Accounting Policies Important?

Accounting policies ensure:

• Consistency: Applying the same methods from period to period.
• Comparability: Allowing for meaningful comparisons between different businesses and over time.
• Reliability: Providing a consistent and trustworthy basis for financial reporting.
• Transparency: Informing users about the methods used to prepare the financial statements.

Examples of Accounting Policies

Common accounting policies include:

• Valuation of Inventory: Methods used to value unsold inventory (e.g., FIFO, weighted average cost).
• Depreciation Methods: How the cost of fixed assets is allocated over their useful life (e.g., straight-line, reducing balance).
• Revenue Recognition: When revenue is recognised in the income statement (e.g., at point of sale, over time).
• Accruals and Prepayments: How expenses and income are recognised when cash is not exchanged.
• Allowances for Doubtful Debts: The method used to estimate and account for potential bad debts.

Disclosure of Accounting Policies

Companies are required to disclose their significant accounting policies in the notes to the financial statements. This allows users of the financial statements to understand the basis on which the financial statements have been prepared.

Table of Common Accounting Policies

Accounting Policy	Description	Example
Inventory Valuation	The method used to determine the cost of goods available for sale and the cost of goods sold.	FIFO (First-In, First-Out), Weighted Average Cost
Depreciation	The method used to allocate the cost of fixed assets over their useful life.	Straight-Line Depreciation, Reducing Balance Depreciation
Revenue Recognition	The point at which revenue is recognised in the income statement.	At point of sale, Over time (for services)
Accruals and Prepayments	How expenses and income are recognised when cash is not exchanged.	Accrued expenses (expenses incurred but not yet paid), Prepaid expenses (expenses paid in advance)
Allowances for Doubtful Debts	The method used to estimate and account for potential bad debts.	Percentage of sales method, Aging of receivables method

Impact of Accounting Policies

The choice of accounting policies can have a significant impact on the financial statements. For example, using FIFO for inventory valuation may result in a higher cost of goods sold than using weighted average cost, leading to a lower profit.

$$ \text{Example: } \text{Consider two businesses with the same sales revenue. If one business uses a higher depreciation rate than the other, it will report a lower profit and a higher retained earnings balance.} $$

Conclusion

Understanding accounting policies is essential for interpreting financial statements. They provide important context and allow users to make informed decisions. Students need to be able to identify and explain the key accounting policies used by businesses and understand their potential impact on the financial results.