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7 Accounting Principles and Policies – IGCSE 0452

7.1 Accounting Principles (the “Fundamental Assumptions”)

The principles form the conceptual foundation for every financial statement. They dictate how transactions are recognised, measured and reported.

Principle What it means Simple illustration
Business Entity The affairs of the business are kept separate from those of its owners. Owner’s personal car is not shown as a company asset.
Going Concern Financial statements are prepared on the assumption that the business will continue to operate for the foreseeable future. Assets are valued at cost, not at forced‑sale prices.
Money Measurement Only transactions that can be expressed in monetary terms are recorded. Employee morale is not recorded, but salaries are.
Historical Cost Assets are recorded at the amount paid for them, not at current market value. A machine bought for £5 000 stays at £5 000 on the balance sheet (apart from depreciation).
Prudence (Conservatism) Potential losses are recognised as soon as they are known; gains are only recognised when realised. Bad debts are estimated and charged to expense, but a gain on re‑selling equipment is recorded only when the sale occurs.
Materiality Only items that could influence the decisions of users need to be disclosed. A £2 stationery purchase is immaterial for a large manufacturing firm and may be omitted from detailed notes.
Matching (Accrual) Expenses are recognised in the same period as the revenues they help generate. Cost of goods sold is recorded when the related sales revenue is recognised.
Duality (Double‑Entry) Every transaction affects at least two accounts – one debit and one credit. Buying inventory on credit debits Inventory and credits Creditors.
Realisation (Revenue Recognition) Revenue is recognised when the earnings process is complete and collection is probable. Revenue from a sale is recorded when goods are delivered, not when cash is received.
Consistency The same accounting policy should be applied from period to period unless a justified change is made. If straight‑line depreciation is used this year, it must continue to be used next year unless a change is disclosed.

7.2 Accounting Policies – Why They Matter

Accounting policies are the specific rules a business adopts to apply the above principles. They determine how transactions are recognised, measured and disclosed.

Objectives of Accounting Policies (AO1‑4)

  • Relevance – Information must affect users’ decisions.
  • Reliability – Information must be based on objective evidence.
  • Comparability – The same policy should be applied from one period to the next; any change must be disclosed (retrospective or prospective).
  • Understandability – Policies must be expressed in plain language and explained where necessary.

Link to exam tasks

Objective (AO) Typical exam question type What examiners look for
Relevance (AO1) Justify the choice of a depreciation method. Explain why the method best reflects the asset’s consumption of economic benefits.
Reliability (AO2) State the measurement basis for inventories. Show that the basis follows the principle of prudence and can be objectively measured.
Comparability (AO3) Discuss the effect of changing a policy (e.g., from FIFO to weighted‑average). Describe retrospective application, the effect on profit/retained earnings and the required note‑disclosure.
Understandability (AO4) Write a short note‑disclosure for a policy. Use clear, concise language; include the key elements required by the syllabus.

Influence of International Accounting Standards (IAS/IFRS) at IGCSE level

IGCSE does not require detailed knowledge of the standards, but students should be aware of the *principles* that underpin the most common policies.

  • IAS 1 – Presentation of Financial Statements: Requires notes to disclose accounting policies and the measurement bases used.
  • IAS 2 – Inventories: Cost or net realisable value, whichever is lower.
  • IAS 16 – Property, Plant & Equipment: Cost model; straight‑line or reducing‑balance depreciation are permitted.
  • IAS 18 (now IFRS 15) – Revenue: Revenue recognised when performance obligations are satisfied and collection is probable.

When writing policies, simply state the principle (e.g., “Inventories are measured at the lower of cost and NRV”) – no need to quote the full standard.

Developing an Accounting Policy – Step‑by‑Step

  1. Identify the transaction or event that requires a policy (e.g., how to value inventory).
  2. Check the relevant accounting principle(s) and, if useful, the associated IAS/IFRS guidance.
  3. Select the method that best reflects the economic reality of the transaction.
  4. Write the policy in plain, concise language, using the exact wording required by the syllabus.
  5. Test the policy on a sample transaction to ensure the numbers are sensible.
  6. Document the policy in the notes to the financial statements, including measurement bases, assumptions and any change from previous periods.

Common Accounting Policies in IGCSE

Area Typical policy (as required by the syllabus) Purpose / Effect
Inventories Measured at the lower of cost and net realisable value (NRV). Prevents over‑statement; follows prudence.
Depreciation Straight‑line (or reducing‑balance where appropriate) over the estimated useful life of the asset. Spreads the cost of the asset over the periods that benefit from it; reducing‑balance reflects higher early usage.
Revaluation of non‑current assets (optional) Cost model is default; if revaluation is used, assets are carried at fair value less subsequent depreciation. Provides a more up‑to‑date value but requires regular revaluation and disclosure.
Revenue Recognition Revenue is recognised when goods are delivered or services performed and collection is probable. Matches revenue with the period in which the related performance obligation is satisfied.
Bad Debts Allowance method – estimate uncollectible amounts as a percentage of credit sales. Provides a realistic estimate of receivables that will not be collected.
Foreign Currency Transactions Recorded at the spot exchange rate on the transaction date; exchange differences are recognised in profit or loss. Ensures the functional‑currency amounts reflect actual cash flows.
Capital vs. Revenue Expenditure/Receipts Capital expenditure creates or enhances an asset and is capitalised; revenue expenditure is incurred to maintain current operations and is expensed. Ensures assets are not overstated and expenses are matched to the period they benefit.

Disclosure Requirements – Checklist for the Notes

For each significant accounting item the following must be disclosed (exact wording mirrors the syllabus):

  • The measurement basis (e.g., “cost”, “lower of cost and NRV”).
  • The method of allocation (e.g., straight‑line depreciation, allowance for doubtful debts).
  • Any change in policy during the period, the reason for the change, and whether it is applied retrospectively or prospectively.
  • If a policy is based on an interpretation of a standard, a brief description of that interpretation.
  • The effect of a change on profit or loss and on retained earnings at the start of the period (when retrospective application is possible).
  • For non‑current assets, state whether the cost model or a revaluation model is used.

Example – Inventory Policy Disclosure

“Inventories are measured at the lower of cost and net realisable value. Cost includes purchase price, import duties, transport and handling costs, and any other costs directly attributable to bringing the inventories to their present location and condition. Net realisable value is the estimated selling price in the ordinary course of business less estimated costs of completion and disposal.”

Example – Depreciation Policy Disclosure

“Property, plant and equipment are stated at cost less accumulated depreciation. Depreciation is calculated on a straight‑line basis over the estimated useful lives of the assets: buildings – 40 years, plant and machinery – 10 years, motor vehicles – 5 years. The residual value of each asset is assumed to be nil. Reducing‑balance may be used for high‑turnover machinery where it better reflects the pattern of economic benefits.”

Changing an Accounting Policy

  • Retrospective application – The new policy is applied to the opening balances of the current period and to all comparable figures of prior periods, unless it is impracticable to do so.
  • Impracticability exception – If restating prior periods is not possible, the change is applied prospectively and the reason is disclosed.
  • Disclosure wording (exactly as the syllabus expects) – State the nature of the change, the reason for the change, and the effect on profit or loss and retained earnings for the current period.

Exam Tips – Scoring Full Marks for Accounting Policies

  1. Read the question carefully – identify the transaction and the specific policy being tested.
  2. State the policy exactly as required by the syllabus (use phrasing such as “measured at the lower of cost and NRV”, “straight‑line depreciation”, etc.).
  3. Explain why the policy satisfies the four objectives (Relevance, Reliability, Comparability, Understandability). One concise sentence per objective is sufficient.
  4. If the question asks for a change, describe:
    • the new policy,
    • how it is applied retrospectively (or prospectively if impracticable),
    • the quantitative effect on profit and retained earnings, and
    • the exact note‑disclosure wording required.
  5. Use the correct terminology: “recognition”, “measurement”, “disclosure”, “retrospective”, “prospective”, “capital vs. revenue”.
  6. Where possible, include a short numeric illustration – examiners reward a simple example that shows the impact of the policy.
  7. AO3 – Evaluation tip: When asked to evaluate a policy choice, compare at least two relevant effects (e.g., impact on profit, working capital, or stakeholder decisions) and give a balanced judgement.
    Model answer fragment:
    “While straight‑line depreciation gives a stable charge each year, reducing‑balance better reflects the higher early usage of the machine. For high‑turnover machinery the latter provides a more realistic picture of profit, so it is the more appropriate choice.”

Summary

Understanding the fundamental accounting principles and the four objectives of accounting policies enables students to:

  • Select appropriate policies for common transactions, including capital vs. revenue treatment.
  • Apply them consistently (Consistency) and transparently.
  • Prepare the required disclosures in the notes, using the exact wording demanded by the syllabus.
  • Answer exam questions confidently, demonstrating knowledge (AO1), application (AO2) and evaluation (AO3).

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