Accounting Policies: The Heart of the Financial System

Accounting policies are the set of rules, principles, and procedures that an entity chooses and applies when preparing and presenting its financial statements. Accounting policies serve as the constitution governing the accounting system, as they determine how to treat various financial transactions, how to measure assets, liabilities, and equity, and how to recognize revenues and expenses. Understanding accounting policies is crucial to ensuring consistency, reliability, and comparability of financial information.

What are Accounting Policies?

Accounting policies are the specific principles, bases, conventions, rules, and practices applied by an entity in preparing ¹ and presenting financial ² statements. accounting policies include an entity’s choices from among the different measurement, recognition, and presentation methods available within accounting standards, such as Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards ³ (IFRS).  

Examples of Accounting Policies:

• Inventory valuation method (First-In, First-Out (FIFO), Last-In, First-Out (LIFO), Weighted-Average).
• Depreciation method for fixed assets (Straight-Line, Declining Balance).
• Revenue recognition basis (at the point of sale, upon delivery, upon collection).
• Treatment of research and development costs (Capitalization or Expensing).
• Investment valuation basis (Cost, Fair Value).

Importance of Accounting Policies:

• Ensuring Consistency of Accounting Treatment: accounting policies help ensure that the same accounting treatments are applied to similar financial transactions, which enhances the consistency of financial data over time and facilitates the comparison of the entity’s performance across different periods.
• Enhancing Comparability of Financial Statements: Applying standardized accounting policies facilitates the comparison of an entity’s financial statements across different time periods, as well as comparing them with financial statements of other entities operating in the same industry, which helps investors evaluate companies’ performance on a comparative basis.
• Improving Reliability of Financial Statements: Clear and appropriate accounting policies contribute to the preparation of more reliable and accurate financial statements, which enhances users’ confidence in these statements and makes them an effective tool for decision-making.
• Facilitating the Audit Process: Documented accounting policies facilitate the internal and external audit process, as they provide a clear framework for reviewing financial transactions and verifying their correctness and compliance with standards.
• Compliance with Accounting Standards: accounting policies help the entity comply with applicable accounting standards, such as GAAP or IFRS, which avoids any violations or legal liabilities.
• Guiding Decision-Making: Accounting Guidelines provide an organized framework for making decisions related to the accounting treatment of complex financial transactions, ensuring consistency and accuracy of decisions.
• Enhancing Transparency: Clear and disclosed Accounting Guidelines enhance the transparency of financial reporting, helping users understand how the financial statements are prepared more effectively.

Selecting Accounting Policies:

When selecting Accounting Guidelines, an entity should consider the following factors:

• Applicable Accounting Standards: Accounting Guidelines must comply with the accounting standards applicable in the country or region where the entity operates, such as IFRS or GAAP.
• Nature of the Entity’s Business: Accounting Guidelines should be appropriate for the nature of the entity’s business, the size of its operations, and its complexity.
• Needs of Financial Statement Users: Accounting Guidelines should provide financial information that is useful and relevant to the needs of financial statement users, such as investors and creditors.
• Consistency Principle: The same Accounting Guidelines should be applied over time to ensure comparability of financial statements, unless there is a strong justification for change.
• Relevance and Reliability: Accounting Guidelines should lead to financial information that is relevant for decision-making and reliable to be depended upon.

Disclosure of Accounting Policies:

An entity must disclose the significant Accounting Guidelines it applies in preparing and presenting its financial statements. These accounting policies are usually disclosed in the notes to the financial statements, which are an integral part of the financial statements.

Importance of Disclosing Accounting Policies:

• Understanding How Financial Statements are Prepared: Disclosing Accounting Guidelines helps users of financial statements understand how different items are measured and presented in the financial statements, enabling them to interpret the financial data correctly.
• Assessing Earnings Quality: Users of financial statements can assess the quality of an entity’s earnings by understanding the accounting policies used in calculating them, and detecting any accounting practices that may lead to inflated profits or reduced losses.
• Comparing Financial Statements: Disclosing Accounting Guidelines facilitates the comparison of an entity’s financial statements with financial statements of other entities operating in the same industry, even if these entities apply different accounting policies.
• Enhancing Transparency and Credibility: Clear and comprehensive disclosure of accounting policies enhances the transparency and credibility of financial statements, increasing the confidence of investors and other stakeholders.

Changes in Accounting Policies:

In some cases, an entity may have to change the Accounting Guidelines it applies. A change in accounting policies should only be made if the change is required by a new accounting standard or if it will result in improved quality of financial information that is more reliable and relevant to the needs of financial statement users.

When changing accounting policies, an entity must:

• Apply the Change Retrospectively: That is, restate the comparative financial statements for prior periods as if the new policy had always been applied, unless it is impracticable to do so.
• Disclose the Nature of the Change: The reason for the change in accounting policies and its impact on the financial statements should be clearly and thoroughly explained in the notes to the financial statements.
• Adjust the Opening Balance of Retained Earnings: The opening balance of retained earnings in the financial period is adjusted for the effect of the change in accounting policies.

Detailed Examples of Accounting Policies:

1. Accounting Policies for Inventory:
   • Valuation Method:
     • First-In, First-Out (FIFO): This method assumes that the goods purchased first are the first to be sold. This method is commonly used in companies that sell perishable goods.
     • Last-In, First-Out (LIFO): This method assumes that the goods purchased last are the first to be sold. (Not permitted under IFRS).
     • Weighted-Average: The cost of goods sold is calculated based on the average cost of all units available for sale during the period.
   • Valuation Basis:
     • Cost: Recording inventory at its purchase cost.
     • Lower of Cost or Net Realizable Value: Recording inventory at the lower of cost or net realizable value.
2. Accounting Policies for Fixed Assets:
   • Depreciation Method:
     • Straight-Line: Allocating the cost of the asset evenly over its useful life.
     • Declining Balance: Charging a larger proportion of depreciation to the early years of the asset’s life.
     • Sum-of-the-Years’ Digits: An accelerated depreciation method that uses a decreasing fraction of the asset’s cost.
     • Units of Production: Depreciation is calculated based on the number of units produced or actual operating hours.
   • Useful Life: Estimating the period of time during which the asset will be used, and the estimated useful life varies depending on the type of asset and the way it is used.
   • Residual Value (Salvage Value): Estimating the value at which the asset can be sold at the end of its useful life.
3. Accounting Policies for Revenue:
   • Revenue Recognition Basis:
     • At Point of Sale: Recognizing revenue upon delivery of goods or provision of service to the customer.
     • Over a Period of Time: Recognizing revenue gradually over the period of service provision (as in long-term service contracts).
     • Upon Completion of Production: Recognizing revenue upon completion of production of the goods (as in some manufacturing industries).
     • Upon Cash Collection: Recognizing revenue only when cash is collected from customers (used in rare cases and when there is significant doubt about collectibility).
   • Treatment of Discounts and Returns: Determining how to treat discounts granted to customers and returns of goods sold.
4. Accounting Guidelines for Investments:
   • Valuation method
   • Cost: Investments are measured at the cost.
   • Fair value: Investments are measured at their market value.
   • Classification of Investments:
     • Available-for-sale investments: They are measured at fair value, and changes are shown in OCI.
     • Trading Investments: they are measured at fair value, and changes are shown in the income statement.
     • Held-to-maturity investments: They are measured at amortized cost (applicable to bonds).

Accounting Standards and Their Relationship to Accounting Policies:

Accounting standards, such as IFRS and GAAP, provide a general framework for preparing financial statements, but they often allow for different alternatives for choosing accounting policies. Therefore, Accounting Guidelines are a detailing and customization of these standards to suit the circumstances of each entity.

Challenges in Applying Accounting Policies in Multinational Companies:

Multinational companies face special challenges when applying Accounting Guidelines across their subsidiaries in different countries, including:

• Differences in Accounting Standards: Accounting standards applicable in the countries where the company’s subsidiaries operate may differ, making it difficult to standardize accounting policies.
• Differences in Exchange Rates: Financial statements of foreign subsidiaries must be translated into the parent company’s reporting currency, which may result in gains or losses due to exchange rate fluctuations.
• Differences in Laws and Regulations: Laws and regulations related to taxes and financial reporting may differ from one country to another, affecting the accounting policies applied.

Role of Technology in Managing Accounting Policies:

Accounting software and Enterprise Resource Planning (ERP) systems help manage accounting policies effectively by:

• Standardizing the Application of Accounting Policies: Accounting software ensures that accounting policies are applied consistently throughout the entity, reducing the risk of inconsistency.
• Automating Accounting Operations: Software reduces human errors and saves time and effort in applying complex Accounting Guidelines.
• Enhancing Internal Control: Software provides tools for internal control over the application of Accounting Guidelines and preventing any transgressions or violations.
• Facilitating Disclosure: Software helps in preparing the notes to the financial statements and disclosing the applied Accounting Guidelines accurately.

Importance of Reviewing and Updating Accounting Policies:

An entity should review its Accounting Guidelines periodically to ensure that they are still appropriate for the nature of its business and that they comply with the latest accounting standards. Accounting policies should be updated when necessary to reflect any changes in accounting standards, the business environment, or management decisions.

Impact of Accounting Guidelines on Earnings Quality and Investor Decisions:

Accounting Guidelines significantly affect the quality of reported earnings, as some accounting policies can lead to inflated profits or reduced losses in a way that does not reflect the entity’s economic reality. Therefore, investors should carefully analyze the disclosed Accounting Guidelines to understand their impact on the financial statement figures and assess whether the reported earnings are of high quality.

Professional Ethics and Accounting Policies: Accountants must commit to the highest standards of ethics when selecting Accounting Guidelines. Accounting policies must provide fairly represented and trusted financial information, and not to manipulate profits.

Conclusion:

Accounting policies are the beating heart of the accounting system, ensuring the preparation of accurate, reliable, and comparable financial statements. Every accountant, and every user of financial statements, should understand the Accounting Guidelines applied by an entity to correctly assess its financial performance and position. Understanding Accounting Guidelines, their importance, and their impact on financial statements is a fundamental element in financial literacy and financial accounting for anyone working in business or seeking to understand how companies operate and achieve success. Without clear and consistent accounting policies, financial statements would be incomplete.