How Accounting Policies and Procedures Help Your Organization

How Accounting Policies and Procedures Help Your Organization

Thursday, February 16, 2017 10:40 pm

Dada Adefolami

By Dada Adefolami

Accounting policies set out the principles to be followed in selecting accounting policies and the disclosures needed to help users to understand the accounting policies adopted and how they have been implemented.

The Accounting Policy Manual includes high-level policies and procedures to ensure that financial activity is recorded accurately and consistently across organizations, so that government-wide financial statements will comply with authoritative Governmental Accounting Standards Board (GASB) and legislative standards.

Accounting policies contrasted with estimation techniques

The distinction between accounting policies and estimation techniques is an important one in practice, because changes in accounting policies are dealt with as prior-year adjustments, whereas changes in estimation techniques are completely reflected in the profit and loss account for the year of change.

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Accounting policies are defined in FRS 18 as ‘those principles, bases, conventions, rules and practices applied by an entity that specify how the effects of transactions and other events are to be reflected in its financial statements’. The accounting policy that is adopted for a particular type of transaction involves making a selection of three factors:

1. Whether or not to recognize elements assets, liabilities, gains or losses as a result of the transaction – recognition criteria.
2. How to attribute a monetary amount to the elements that are recognized – measurement bases.
3. Where to present the elements in the financial statements.

Estimation techniques are the methods adopted by an entity to arrive at the estimated monetary amounts corresponding to the measurement bases selected for elements of the financial statements. The distinction between accounting policies and estimation techniques is important. FRS 18 says that a change of accounting policy has occurred where there has been a change to any one of the components of the definition:
1. Recognition criteria
2. Measurement basis
3. Method of presentation

Conversely a change that does not affect any of the above is a change in estimation technique. The FRS provides a number of examples and it will be useful to review some of them.

Example 1: capitalized finance costs
An entity has previously written all finance costs off to the profit and loss account as incurred. The entity now wishes to capitalize interest on borrowing incurred to finance the construction of fixed assets. This decision involves a change in:

1. Recognition – the costs are now included as part of an asset
2. Presentation – the costs are now presented in the balance sheet rather than the profit and loss account
Therefore the decision represents a change in accounting policy.

Example 2: depreciation of vehicles

An entity has previously depreciated vehicles using the reducing balance method at 40% per year. It now proposes to depreciate vehicles using the straight-line method over five years. This decision does not involve a change in any of the three key criteria:

1. The fixed assets are still carried at cost less accumulated depreciation.
2. The depreciation is still allocated to individual accounting periods so as to reflect the consumption of economic benefits.
3. In the absence of information to the contrary fixed assets and depreciation are presented in the same way in the balance sheet and the profit and loss account respectively.
Therefore this is a change in estimate and not a change in accounting policy.

Example 3: accounting for fungible stocks
Fungible stocks are stocks that are indistinguishable from one another, for example identical nuts and bolts. The current policy is to consider such stocks in aggregate and measure them at their weighted average historical cost. However the entity decides to measure such stocks at historical cost on a FIFO basis. This decision involves a change in the basis used to measure stocks and as such represents a change in accounting policy.

Selection of accounting policies
General principles:
Not surprisingly FRS 18 states that entities should adopt accounting policies that enable the financial statements to give a true and fair view. Just as predictable is the statement in FRS 18 that accounting policies should normally be consistent with the requirements of accounting standards and companies legislation. If, in exceptional circumstances, compliance with a particular accounting standard is inconsistent with the requirement to give a true and fair view then entities are permitted to depart from the requirements of that standard. Such instances are likely to be rare and the author would be reluctant to give a specific example!

Accounting Policies is the Principles, rules and procedures selected, and consistently followed, by the management of an organization in preparing and reporting

Key concepts

FRS 18 states that two concepts, the going concern concept and the accruals concept play a pervasive role in the selection of accounting policies.

Financial statements are usually prepared under the assumption that the entity is a going concern. This is because measures based on break-up values tend not to be relevant to user seeking to assess the entity’s ability to generate cash and be financially adaptable. When preparing financial statements directors should assess whether there are significant doubts about an entity’s ability to continue as a going concern.

Other than in the cash flow statement the accruals basis of accounting requires the non-cash effects of transactions to be reflected in the financial statements for the period in which they occur. FRS 18 states that the accruals concept lies at the heart of the definitions of assets and liabilities that are set out in FRS 5 ‘Reporting the Substance of Transactions’.

The concept of accruals is closely related to the concept of realization. Company’s legislation only allows profits that are realized by the balance sheet date to be included in the profit and loss account. Unfortunately such legislation fails to give an adequate definition of ‘realized’. FRS 18 does not seek to define the term ‘realized’ in its definitions section but does link realization with the creation of new assets and liabilities and therefore with the concept of accruals.

Objectives against which accounting policy selection should be judged:
These are those outlined in the Statement of Principles as being desirable characteristics of useful financial information:
1. Relevance
2. Reliability
3. Comparability
4. Understandability

Relevant financial information has the ability to influence the economic decisions of users and is provided in time to influence those decisions. Relevant information possesses either predictive or confirmatory value or both.
Reliable financial information must:

1. Faithfully represent the transactions of the entity and therefore reflect their substance.
2. Be neutral free from bias.
3. Be free from material error.
4. Be complete within the bounds of materiality.
5. Be prudently prepared under conditions of uncertainty. However, where no uncertainty exists prudence need not be exercised.

Useful financial information should be comparable with financial information of the entity that relates to a different period and with financial information relating to other entities. In practice comparability is achieved by a combination of consistency and disclosure.

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