Accounting Policies: Definition, Selection Criteria & Impact on Financial Statements | CA Foundation Unit 5 Notes

Unit 5: Accounting Policies: Accounting policies are the specific principles and methods applied by an enterprise in preparing and presenting its financial statements. These policies vary depending on the business context and must be selected carefully to ensure the financial statements reflect a true and fair view.

The selection is guided by key concepts such as prudence, substance over form, and materiality. A change in accounting policies is permitted only when required by law or accounting standards, or if it leads to a more appropriate presentation of financial data. Such changes must be disclosed and their impact on the financial statements quantified.

Unit 5: Accounting Policies – Exam Notes

Learning Objectives

After studying this unit, you will be able to:

• Understand the meaning and significance of accounting policies.
• Know how and when to select accounting policies.
• Understand when changes in accounting policies are permitted and their effects.

1. Meaning of Accounting Policies

Accounting Policies are:

• Specific accounting principles and methods used by a business in preparing financial statements.
• Based on fundamental accounting concepts, principles, and conventions (like those in Unit 2).
• Not uniform across all enterprises — policies vary based on business needs, legal requirements, and industry practices.

Examples of accounting policies:

• Inventory Valuation: FIFO, weighted average, etc.
• Investment Valuation: At cost, market value, or net realizable value.

2. Selection of Accounting Policies

Why selection matters:

• Affects the financial performance and position of the business.
• Inappropriate policies can understate or overstate assets, liabilities, income, or expenses.

Key principles for selection:

• Prudence – Avoid overstatement of income/assets.
• Substance over form – Reflect economic reality, not just legal structure.
• Materiality – Consider only information that influences decisions of users.

Example:

Inventory may be valued at cost, or lower of cost and net realizable value, depending on what best reflects the business reality.

3. Change in Accounting Policies

Changes allowed when:

1. Required by law or accounting standards.
2. Results in better, more appropriate financial reporting.

Impact:

• Change can significantly affect assets, liabilities, or profit/loss.
• It is necessary to quantify and disclose the impact of any change.

Example:

Changing inventory valuation method from weighted average to FIFO.

Summary Points

• Accounting policies = principles + application methods used in financial statements.
• Policies should reflect prudence, substance over form, and materiality.
• No single list of policies is applicable to all businesses.
• Changes are allowed only for legal compliance or better presentation, and must be quantified and disclosed.

Test Your Knowledge

True or False

1. A single list of accounting policies applies to all businesses. → ❌ False
2. Selection of accounting policy has no impact. → ❌ False
3. Change in policy can be made anytime. → ❌ False
4. Choosing FIFO is part of policy selection. → ✅ True
5. Inappropriate policy always overstates financials. → ❌ False

MCQs

1. A change in policy is justified when:
   ✅ (c) Both compliance and better presentation
2. Inventory valued at lower of cost or NRV is based on:
   ✅ (b) Prudence
3. Areas with different policies:
   ✅ (b) Valuation of inventories
4. Inappropriate policy may:
   ✅ (b) Understate or overstate performance
5. Accounting policies refer to:
   ✅ (c) Both principles and methods

Important Theoretical Questions

1. Define Accounting Policies and give examples.
→ Policies refer to specific principles and methods applied in preparing financial statements.
Examples:

• Inventory valuation methods (FIFO, Weighted Average)
• Investment valuation (Cost or NRV)

2. Explain how a change in policy affects financials.
→ A change (e.g., inventory valuation method) can increase or decrease profits, assets, or liabilities. The impact must be quantified and disclosed to ensure transparency.

Here are the maximum possible FAQs (Frequently Asked Questions) based on Unit 5: Accounting Policies — designed to help you with revision, concept clarity, and exam prep:

FAQs – Accounting Policies (Unit 5)

1. What are accounting policies?
Accounting policies are specific principles and methods applied by an enterprise in the preparation and presentation of its financial statements.

2. Why are accounting policies important?
They ensure consistency, comparability, and accurate presentation of financial performance and position.

3. Are accounting policies the same for all enterprises?
No, policies vary depending on the industry, business environment, and regulatory requirements.

4. On what basis should accounting policies be selected?
Selection should be based on:

• Prudence
• Substance over Form
• Materiality

5. What is the principle of prudence?
It means not overstating assets or income and not understating liabilities or expenses.

6. What is ‘substance over form’?
It means financial reporting should reflect the economic reality of transactions, not just their legal form.

7. What is materiality in accounting policies?
Only information that would influence users’ decisions needs to be disclosed or accounted for.

8. Can enterprises change their accounting policies at will?
No, changes are allowed only:

• To comply with statutes or accounting standards
• If it results in more appropriate presentation

9. What is the effect of changing an accounting policy?
It can materially affect assets, liabilities, profits, and must be quantified and disclosed.

10. How should a change in accounting policy be reported?
The enterprise must quantify its impact and disclose it in the financial statements.

11. Give an example of an accounting policy.
Choosing FIFO or weighted average method for inventory valuation is an example.

12. What are some common areas where different policies are used?

• Inventory valuation
• Investment valuation
• Depreciation methods
• Treatment of R&D costs

13. Does disclosing a wrong policy correct the error?
No. Disclosure does not rectify the wrong or inappropriate accounting treatment.

14. What happens if inappropriate accounting policies are selected?
They may overstate or understate financial results and mislead users.

15. What are the consequences of not disclosing a change in policy?
It can lead to non-compliance, misrepresentation, and affect stakeholder trust.

16. Is there a standard list of accounting policies every firm must follow?
No. There is no single exhaustive list; policies differ based on specific circumstances.

17. Can two companies in the same industry use different policies?
Yes, depending on management judgment and business structure.

18. What is meant by “more appropriate presentation”?
It means providing a clearer, more accurate, and reliable picture of financial health.

19. Who decides which accounting policies to adopt?
Typically, it’s the management of the enterprise, within the framework of legal and regulatory norms.

20. Can accounting policy changes affect net profit?
Yes, for example, changing inventory valuation from weighted average to FIFO may increase or decrease profits.

Accounting policies play a crucial role in ensuring accurate financial reporting. These policies, which are based on specific principles and methods, provide a framework for the preparation and presentation of financial statements. The selection of accounting policies must be done carefully, considering the impact on the financial performance and position of the enterprise, guided by principles like prudence, substance over form, and materiality. Changes in accounting policies can have a significant effect on the financial statements and must be disclosed and quantified accordingly.

On the other hand, contingent assets and liabilities are tied to uncertain future events, and while contingent assets may present possible inflows, contingent liabilities represent potential obligations. These items are not directly recorded in financial statements unless the likelihood of realization or obligation becomes certain, at which point they are recognized. The distinction between contingent liabilities and actual liabilities, as well as between contingent liabilities and provisions, is essential for accurate financial reporting and understanding of the company’s obligations.