The Hindu Business Line : Accounting policy disclosure should not be a mere formality

A proper accounting policy is complete, unambiguous, user-friendly and is in accordance with the requirements of law and accounting standards. Here is continuing with some simple guidelines, for drafting proper accounting policies.

Accounting policy should be complete

The accounting policies of certain companies are not complete. For example, the policy relating to investments in the financial statements of certain companies is stated simply, `Investments are valued at cost'. This does not indicate whether the investments are long-term or current (only on a perusal of the balance-sheet, does it become clear how the company has classified them). Further, even if the investments are long-term, the accounting policy is incomplete because it does not state whether the company follows the policy of making a provision for decline, other than temporary, in their value.

Another example is the policy on valuation of raw material inventories. Some financial statements simply say that "inventories of raw material are valued at cost." This creates an impression that the company does not consider, as a matter of policy, the net realisable value for the purpose of valuation of its raw material inventories, which is incorrect as Accounting Standard 2 — `Valuation of Inventories' — clearly requires that all inventories, including of raw materials, should be valued at the lower of cost and the net realisable value.

It is sometimes argued that the relevant financial statements have been prepared after considering the net realisable value, and that the inventories have been valued at cost as that is lower than the net realisable value. Even if that be so, it would be right to state the accounting policy in accordance with the requirements of the standard as otherwise it would create a wrong impression that the net realisable value was never considered for the purpose of valuation of inventories of raw material, whereas, in fact, the company has followed the correct accounting policy.

Accounting policies should be user-friendly

In certain cases, the accounting policy is ambiguous, that is, it is stated in a manner that does not provide adequate information to the users as to whether the policy is in accordance with the relevant Accounting Standards.

In many cases, the reason for adoption of an accounting policy is not clear. For example, the accounting policy relating to revenue recognition stated in the balance-sheet of a company carrying on the business of indirect carrier of goods simply states: "Revenue is recognised at the time when the goods are received from the customer and the invoice is made out in his name." This policy does not indicate why revenue has been recognised at the time when the goods are received from the customer and how it is in accordance with the requirements of the Accounting Standard 9 on Revenue Recognition.

In contrast to this accounting policy, the following accounting policy followed by another company carrying on the same business states:

"The Company derives its revenues from two main sources: air and ocean freight. As a non-asset-based carrier, the company does not own transportation assets. It generates the major portion of its revenues by purchasing freight services from asset-based shippers and reselling those services to customers. By consolidating shipments from multiple customers and by purchasing cargo space in bulk, the company can negotiate more favourable rates from the shippers than the customers could negotiate on their own. Revenues include the charges to the company from the shipper carrying the freight. For export freight, the company receives a Master Airway Bill for air shipments and a Master Ocean Bill of Lading for ocean shipments when the freight is delivered to the shipper. With the exchange of this contract, the risk of loss and rewards are passed to the buyer. Revenue is, therefore, recognised at that time." These are some simple rules for drafting proper accounting policies. Another aspect that is often noticed on a perusal of the statement of significant accounting policies disclosed in the published financial statements of various companies is that sometimes the accounting policies which should normally appear in the financial statements are not included. An issue, therefore, arises as to which accounting policy should be disclosed in the financial statements. The existing Accounting Standard 1 — Disclosure of Accounting Policies — does not provide guidance in this regard. While it is obvious that the accounting policies specifically required to be disclosed by an accounting standard have to be disclosed, International Accounting Standard (IAS) 1, Presentation of Accounting Statements, provides some guidance in this regard as follows:

Disclose accounting policies that are selected from the alternatives allowed:

According to IAS-1, disclosure of a particular accounting policy is especially useful to users of financial statements when that policy is selected from alternatives allowed in various accounting standards. This principle can also be extended to include the alternatives allowed in the Guidance Notes issued by the Institute of Chartered Accountants of India. For example, the Guidance Note on `Accounting for Oil and Gas Producing Activities,' issued by the ICAI permits oil exploration and production companies to follow either full costing method or successful efforts method. In view of this, it would be useful for the users of the financial statements of a company involved in exploration and production of oil to provide information about the method of accounting followed by it.

Disclose accounting policies that the users of financial statements would expect to be disclosed for that type of entity:

Every enterprise should consider the nature of its operations and the policies that the users of its financial statements would expect to be disclosed for that type of entity. For example, an enterprise subject to income taxes would be expected to disclose its accounting policies for income-taxes including those applicable to deferred tax assets and liabilities. When an enterprise has significant foreign operations or transactions in foreign transactions in foreign currencies, disclosure of accounting policies for the recognition of foreign exchange gains and losses would be expected.

Similarly, all enterprises have revenue-generating activities. Thus, revenue recognition policy should invariably find place in the statement of significant accounting policies. However, on a perusal of the financial statements of certain companies, it has been noted that some companies have not disclosed the accounting policies related to revenue recognition.

Disclose accounting policies in respect of the transactions which are not covered by an accounting standard/guidance note/legal requirements:

It is possible that the nature of operations of a company are such that some of its transactions are not covered by the accounting standards/guidance notes issued by the Institute of Chartered Accountants of India or by the relevant legislation.

In such a situation, the management has to use its judgment in developing and applying an accounting policy in accordance with the general principles of accounting. Such accounting policies should also be disclosed by the companies.

Industry-specific accounting policies:

There are certain industries which may have peculiarities on application of Accounting Standards in view of their nature of activities. For example, the accounting treatment of removal of over-burden by a mining company is a peculiarity in mining industry. The accounting policy followed by the company in this regard would be useful for the users of the financial statements.

The above guidance on selection and drafting of accounting policies is not exhaustive. Ultimately, the management has to follow the general rule as to which accounting policies would assist the users in understanding how transactions, other events and conditions are reflected in the financial statements.

Similarly, while drafting an accounting policy the management has to consider the best manner in which the accounting policy would assist the users in understanding the accounting treatment of transactions, other events and conditions involved in the preparation of financial statements of an enterprise.

It should be appreciated that the purpose of disclosing accounting policies in the financial statements is not to comply, in form, with the requirements of AS 1 by merely giving a perfunctory list of a few accounting policies; the purpose is to comply with the spirit of the standard to assist users to understand the financial statements. It should be remembered that the accounting policies, amongst other things, indicate whether other accounting standards have been properly followed.

(Concluded)

(The author is Technical Director, ICAI.)

Related Stories:
There should be accounting for policies

More Stories on : Accounting Standards | Corporate Governance

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Accounting policy disclosure should not be a mere formality

Accounting for demerger is uniform across the globe

Should telecom charges fall further?

Cooks, cleaners and free trade

Instalments that make the grade

A function of taxes

MBA with or without experience

Sports economics is serious business

Number Crunch

Just Do IT

Corruption in road projects

Leadership skills are learnt

Shut down the useless internal chatter

Information vs communication