Accounting Policies

Accounting policies are the specific principles, bases, conventions, rules, and practices applied by a business in preparing and presenting its financial statements.

Think of accounting principles (concepts) as the broad rules that everyone must follow (e.g., accruals, prudence, consistency). Accounting policies are the specific choices a business makes within those rules. For example:

• The accruals principle says depreciation must be charged. The depreciation policy says HOW — which method (straight-line or reducing balance) and at what rate.
• The prudence principle says inventory should not be overstated. The inventory policy says which valuation method to use (FIFO or AVCO).

Why do policies matter? Different, equally valid choices produce different profit figures and asset values. This means:

1. Two businesses with identical trading activities can report different profits.
2. The same business can report different profits in different years if it changes its policy.
3. Ratio comparisons between businesses using different policies are unreliable.

Disclosure requirement: Accounting policies must be stated in the notes to the financial statements so that users can understand how the figures have been calculated. This transparency allows users to make informed adjustments when comparing different businesses.

IAS 1 (International Accounting Standard 1) — referenced in some Cambridge contexts — requires that accounting policies are:

• Consistently applied from period to period
• Changed only when required by an accounting standard or when the change gives a fairer presentation
• Disclosed, with the effect of any change explained

When a business acquires a non-current asset, it must choose a depreciation method. The two main methods in Cambridge 0452 are straight-line and reducing balance.

Straight-Line Depreciation

$\text{Annual charge} = \frac{\text{Cost} - \text{Residual Value}}{\text{Useful Life (years)}}$

• The annual depreciation charge is equal every year.
• The asset's net book value (NBV) declines steadily in a straight line to residual value.

Reducing Balance Depreciation

$\text{Annual charge} = \text{Net Book Value at start of year} \times \text{Rate\%}$

• The annual charge is higher in early years and decreases over time (because it is applied to a shrinking NBV).
• The NBV never quite reaches zero.

Effect on profit and ROCE:

Consider an asset costing $100,000, no residual value, 10-year life:

• Straight-line: $10,000 per year every year
• Reducing balance at 25%: Year 1 = $25,000; Year 2 = $18,750; Year 3 = $14,063...

In Year 1, the reducing balance method gives a higher depreciation charge → lower profit → lower profit margin. In Year 10, the straight-line charge is still $10,000 but reducing balance is only ~$750 → reducing balance shows higher profit in later years.

ROCE is also affected: different depreciation charges produce different net book values. A business using straight-line will have a higher net book value (larger capital employed) in early years than one using reducing balance, affecting the denominator of ROCE.

The key exam scenario: Two businesses buy identical machinery. Business A uses straight-line; Business B uses reducing balance. In year 1, Business B will report lower profit and lower ROCE — not because it is less efficient, but purely because of its depreciation policy choice.

The choice between First In, First Out (FIFO) and Average Cost (AVCO) for inventory valuation affects:

1. The value of closing inventory on the statement of financial position
2. The cost of sales in the income statement
3. Gross profit and, therefore, the gross profit margin

FIFO (First In, First Out) Assumes that the oldest inventory is sold first. Closing inventory is valued at the most recent purchase prices.

AVCO (Weighted Average Cost) Every time new inventory is purchased, a new weighted average cost per unit is calculated. Closing inventory is valued at the current weighted average cost.

Effect in a period of RISING prices (inflation):

	FIFO	AVCO
Cost of sales	Uses older (cheaper) prices	Uses average prices
Closing inventory	Valued at recent (higher) prices	Valued at average prices
Gross profit	Higher (lower cost of sales)	Lower than FIFO

• Under FIFO, the cheaper older purchases are allocated to cost of sales, leaving the more expensive recent purchases in closing inventory. This gives a higher gross profit in rising price conditions.
• Under AVCO, the cost of sales uses a blended average — neither the cheapest old prices nor the most expensive recent prices.

Example: A business buys 100 units at $10 each in January, then 100 units at $12 each in March. It sells 100 units during the period.

• FIFO cost of sales = 100 × $10 = $1,000; closing inventory = 100 × $12 = $1,200
• AVCO: average cost = ($10 + $12) ÷ 2 = $11; cost of sales = 100 × $11 = $1,100; closing inventory = 100 × $11 = $1,100

Result: FIFO reports $100 lower cost of sales → $100 higher gross profit.

In falling price conditions, FIFO gives lower closing inventory and lower gross profit than AVCO (the roles reverse).

Exam scenario: 'Explain why two businesses with identical sales and purchases report different gross profit margins.' Answer: They use different inventory valuation methods. If prices have been rising, the FIFO business will have a lower cost of sales, higher gross profit, and higher gross profit margin than the AVCO business.

A business extending credit to customers knows that some debts may never be collected. The provision for doubtful debts (also called allowance for doubtful debts) is a prudent estimate of the value of trade receivables that may prove irrecoverable.

Policy choice: what percentage of trade receivables to provide for. Different businesses in the same industry may choose different rates (e.g., 2%, 3%, or 5%).

Effect on financial statements:

• The provision is charged as an expense in the income statement → reduces net profit.
• The net trade receivables on the statement of financial position = gross trade receivables − provision.

Example: Trade receivables = $80,000.

• Business A: provision = 2% → provision = $1,600; net trade receivables = $78,400; expense = $1,600
• Business B: provision = 5% → provision = $4,000; net trade receivables = $76,000; expense = $4,000

Business B shows $2,400 less profit and $2,400 less in net trade receivables than Business A — with identical trading activities. This is purely a policy difference.

Changes to the provision: if the provision % increases year-on-year, an increase in the provision is charged as an additional expense. If the provision decreases, the decrease is credited to the income statement (reduces expenses, increases profit). This creates volatility in reported profits even when trading is stable.

A sophisticated understanding of accounting policies requires connecting policy choices to their specific impact on ratios.

Policy Choice	Ratios Affected	How
Straight-line vs Reducing balance (early years)	Profit margin, ROCE, net book value of assets	Reducing balance: higher depreciation → lower profit margin; higher depreciation → lower NBV → lower capital employed → higher ROCE in some years
FIFO vs AVCO (rising prices)	Gross profit margin, profit margin	FIFO: lower cost of sales → higher GPM and profit margin
Higher provision for doubtful debts	Profit margin, net trade receivables	Higher provision → lower net profit → lower profit margin; lower net trade receivables on SFP

The key exam question: 'Explain why two similar businesses may report different profit figures even though their trading activities are identical.'

Model answer framework:

1. State that different accounting policies can produce different profit figures
2. Give a specific example (e.g., different depreciation methods or different inventory valuation methods)
3. Explain the mechanism (e.g., 'if Business A uses straight-line depreciation at 10% and Business B uses reducing balance at 25%, Business B's depreciation charge will be higher in early years, resulting in lower profit')
4. Conclude that the difference reflects accounting policy, not trading performance

This is a 4–6 mark question that rewards depth and specificity.