American Journal of Economics, Finance and Management

Vol. 1, No. 3, 2015, pp. 190-194

http://www.aiscience.org/journal/ajefm

Choice of Accounting Policy: Effects on Analysis

and Interpretation of Financial Statements
Sunday Adebayo Alayemi*
Faculty of Business and Social Sciences, Department of Accounting, Adeleke University, Ede, Osun State, Nigeria

Abstract
This paper examined the effect of accounting policy adopted by the reporting entity on the analysis and interpretation of financial
statements. It is mandatory according to the Statement of Accounting Standards (SAS NO.1) and International Accounting
Standards (IAS 1) for every reporting entity to disclose the accounting policy adopted in the preparation and presentation of
financial statement. Accounting policies are very important for the proper understanding of the information provided in the
financial statements. An entity should clearly state the accounting policies it has used while preparing and presenting the financial
statements. Disclosure of accounting policies is important because many accounting standards allow alternative treatments for a
same transaction or item. Users of financial statements will not be able to compare the financial information with other entities if
the accounting policies are not cleared outlined. Therefore, by stating the policy adopted, this will make it possible for the readers
and users of financial statements to make informed decision. The users will as well be able to see the impact of accounting
policies on the income statement and financial position of the reporting entity within the industry.
Keywords
Accounting Policy, Financial Statement, Reporting Entity, SAS, IAS
Received: April 8, 2015 / Accepted: April 20, 2015 / Published online: May 11, 2015
@ 2015 The Authors. Published by American Institute of Science. This Open Access article is under the CC BY-NC license.
http://creativecommons.org/licenses/by-nc/4.0/

1. Introduction
Financial statement is the source of information through
which the user groups assess the company. However, the
information provided by the financial statement should be
useful for its intended purpose. The primary objective of
corporate report is to communicate economic measurements
and information about the resources and performance of the
reporting entity useful to those having reasonable rights to
such information. A reasonable right to information exists
where the activities of an organization impinge or may
impinge on the interest of a user group [1].
Therefore, financial statement is periodic financial
information which shows the profit or loss and the state of
affairs of the business organization. It is prepared periodically,
usually at the end of the year.Accordingto[2] financial
statement as an integral and important part of the broad field
* Corresponding author
E-mail address: [email protected]

of business analysis is the process of evaluating a company

economic prospects risks. This involves analysis of a
companys business environment, its strategies and its
financial position as well as performance.In the words of [3]
financial statement is the expression of the worth of the
company through the end period balance sheet. Hence it is
the communication of the activities of the company in a
period of year added to the preceding period to give an end of
a new period position.
Financial statements provide valuable information for both
the owners of the business and for any potential
owners/investors. From the users group, it is possible to
identify three general areas of interest in which users needs
and objectives may lie:
Financial status can the business pay its way, is it in fact
liquid?

American Journal of Economics, Finance and Management Vol. 1, No. 3, 2015, pp. 190-194

Performance how successful is the business, is it making

a reasonable profit, is it utilizing its assets to the fullest, is
it in fact profitable and efficient?
Investment is the business a suitable investment for
shareholders or would returns be greater if they invested
elsewhere, is it a good investment?

2.Purpose of the Study

The main trust of this paper is to theorize that the choice of
accounting policy has effects on the analysis and
interpretation of financial statements even if the same data is
used.

3. Contents of Financial
Statements
According to[4] financial statements of a firm is defined to
consist of three main accounts: the balance sheet, the profit
and loss account and cash flow statement.
3.1. The Statement of Financial Position
This is the statement where the assets and liabilities of the
reporting entity are disclosed. Although no prescribed format
for the statement of financial position is required by [5], it
does set out the minimum information which is required to be
presented in the statement, as set out below:
property, plant and equipment;
investment property;
intangible assets;
financial assets not disclosed in other headings below;
investments accounted for using the equity method;
biological assets;
inventories;
assets/disposal groups classified as held for sale;
trade and other receivables;
cash and cash equivalents;
liabilities included in disposal groups classified as held for
sale;
trade and other payables;

191

non-controlling interest, presented within equity; and

issued capital and reserves attributable to owners of the
parent.
However, amendments may be made to the ordering of items
if bysodoing the new presentation provides more relevant
information to the users of the financialstatements.
Additional line items, headings and subtotals should be
added where relevant tothe understanding of the financial
statements. [6]Property, plant and equipment requires
information to be disaggregated into classes of assets, for
example freehold buildings, plant and machineryand office
equipment.
It is also required by [5] that specific information is presented
in relation to the share capital of theentity. These disclosures
include identifying:
The number of shares authorised;
The number of shares issued and fully paid, and issued but
not fully paid;
The par (nominal) value per share, or that the shares have
no par value.
In addition, a full reconciliation of the movement during the
year in the number of shares outstanding is required,
specifying any rights, preferences and restrictions attaching
to theshares. Disclosure should also be made of any shares in
the entity, held by the entity or by its subsidiaries or
associates and any shares reserved for issue under options
and contracts forthe sale of shares.
Where an entity does not have share capital, equivalent
information should be disclosed.
3.2. The Statement of Comprehensive
Income
It is stated by [5] that, as a minimum, the following
information is required to be presented in thestatement of
comprehensive income for the period:
revenue;
finance costs;
share of the profit or loss of associates and joint ventures
accounted for using the equity method;
tax expense;

financial liabilities not disclosed in other headings above;

an aggregate figure for the profit or loss of discontinued

operations and the gain orloss in relation to the remeasurement, or disposal, of discontinued operations;

liabilities and assets for current tax;

profit or loss;

deferred tax liabilities and assets;

share of other comprehensive income of associates and

joint ventures accounted forusing the equity method;

provisions;

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Sunday Adebayo Alayemi: Choice of Accounting Policy: Effects on Analysis and Interpretation of Financial Statements

each component of other comprehensive income classified

by nature;
total comprehensive income;
the profit or loss attributable to non-controlling interest
and that attributable to owners of the parent; and the total
comprehensive income attributable to non-controlling
interest and that attributable to owners of the parent.
Other comprehensive income comprises items of income and
expense which are not required by other [7] to be recognised
in profit or loss.
How a choice is to be presented in comprehensive income is
permitted by [5]:
In a single statement of comprehensive income; orin two
statements: an income statement (which includes only those
items which are required to be recognised in profit or loss)
and a statement of comprehensive income (which begins with
the profit or loss per the income statement and then displays
the components of other comprehensive income).
As explained above for the presentation of the statement of
financial position, additional line items, headings, subclassifications and subtotals should be added where relevant
to the understanding of the financial statements. If an item of
income or expenditure is important to the fundamental
understanding of the performance of the entity during the
period, this item should be disclosed separately. Examples of
such items include a significant write down (a loss in value)
of property, disposals of investments or where the entity has
discontinued some of its operations during the period.
Entities are required to present an analysis of expenses
recognised in profit or loss, but [5] permits a choice as to
how the expenses are classified. The classification should be
based either on the nature of expenses, highlighting the main
types of expenditure incurred, for example staff costs and
raw materials, or on the function of expenses. The latter
classification presents expenses under headings such as cost
of sales or administration costs; this classification generally
requires considerable judgment to ensure that allocations of
the expenditure are appropriate.

4. Financial Accounting Theory

In financial accounting theory, according to [8] companies
choose their accounting methods so as to present truth and
fairness on their activities. These choices, however, is
employed in the accounting policies of the reported entity.
These policies are the bases of drawing up and interpreting
their financial statements. From the foregoing, accounting
policicy is influenced by Normative and Positive accounting
theory.

4.1. Normative Accounting Theory

There are five important work on normative accounting
theory as carried out by [9,10, 11, 12 and 13]. Normative
accounting theory seeks to prescribe some bases of
accounting, measurement, particular accounting procedures
and the contents of financial reports [13 and 14]. In
furtherance of his work[13] differentiate between normative
theory and policies. According to him, in normative theory,
researcher does not commit himself/herself to the goal
assumed but in the case of accounting policy, the researcher
is committed to the goal. Hence, normative theory attempts
to tell what the people or constituencies should do. Therefore,
normative theory is not solely evaluated by predictive value,
but is also evaluated by its logical consistency. Hence,
normative theory attempts to state what financial information
should be collected, analysed and communicated.
4.2. Positive Accounting Theory
This is a positive theory, that aims at predicting action such as
which accounting policies firms will choose and how newly
proposed accounting standards will cause firms to react. The
study carried out by [15] help give an understanding why
different companies will choose different accounting policies
and why managers may object to changes in these accounting
policies. In addition, the study revealed why investors may
react to the potential impact of changing accounting policies.
Positive accounting policy has three hypotheses around which
its prediction are organized namely: the bonus plan hypothesis,
the debt covenant hypothesis and political hypothesis.
4.3. Statement of Accounting Policy
Accounting policies are very important for the proper
understanding of the information provided in the financial
statements. An entity should clearly state the accounting
policies it has used while preparing the financial statements.
Disclosure of accounting policies is important because many
accounting standards allow alternative treatments for a same
transaction or item. Users of financial statements will not be
able to compare the financial information with other entities
if the accounting policies are not cleared outlined.
Therefore, accounting policies are those bases, rules,
principles, conventions and procedure adopted in the
preparation and presenting financial statements.

5. Choice of Accounting Policy

In the choice and application of the appropriate accounting
policies, some fundamental concepts contradict one another.
Hence, when choosing application of appropriate accounting
policies, the following should be considered:

American Journal of Economics, Finance and Management Vol. 1, No. 3, 2015, pp. 190-194

193

5.1. Substance over form

adopted in the recognition of profit.

Transactions and other events should be accounted for and

presented in accordance with their substance and financial
reality and not merely with their legal form.

Goodwill valuation and method of elimination from the

financial statements.
Leases allocation between operating and finance lease,
method of allocating finance charges relating to both lease
and lessor.

5.2. Objectivity
The accountant should be objective when presenting
financial information. The preparer of financial information
should not be bias or try to favour a segment of users of
financial statement.

Research and development policy regarding possible

capitalization of development costs and policy on any
resulting amortization.

5.3. Fairness

Pensions- problems associated with the type of scheme,

the valuation of surplus or deficit and the allocation of
these and other costs over accounting periods.

This is an extension of the objectivity. Accounting

information should be prepared not to favour any group or
segment of society.
5.4. Materiality
Financial statements should disclose all items which are
material enough to affect evaluation of decisions.
5.5. Prudence
Uncertainties surround many transactions. This should be
recognised by exercising prudence in preparing financial
statements. However, prudence does not justify the creation
of secret reserves.

6. Financial Statement Analysis

Financial statement analysis seeks to evaluate management
performance in several important areas such as profitability,
efficiency and risk. Ratios are usually employed in
interpreting and analyzing financial statement. There are
limitations within ratio analysis. However, the major
limitation is the problem encountered when companies used
different accounting policies within their financial statements.
The choice of accounting policy could, however,
significantly affect the analysis and interpretation of
published financial statements in the following ways:
Policy on asset valuation particularly regarding land and
building. In this situation, historical may or may not be
departed from. This will affect profit through depreciation
charges and balance sheet structure.
Depreciation policy of certainty will have effect on profit
and assets value.
The method adopted in the valuation of stock will impact
profit, assets value as well as liquidity ratio through the
cost flow assumption made (LIFO, FIFO) and also the
treatment of overheads.
Long term contract assumptions, for example method

Use of temporal or closing rate method for translation of

foreign trading operation.
Consolidation policies that are definitions relating to the
distinction between subsidiary and associate, use of
acquisition or merger accounting, quantification of fair
values will all affect the numbers in the financial statements.
Hence, in analyzing and interpreting financial statements, it
is very important to take into cognizance the accounting
policies adopted by the reporting entity. This will enable the
users to know how the accounting policies impact the items
in the financial position and income statement.

7. Conclusion
The accounting policy to be chosen is part of the need for the
firm to reduce contracting costs. Therefore, different
accounting policies that can be employed by a reporting
entity have significant impact on the interpretation of
financial statements through ratio analysis. The different
accounting policies affect the income statement as well as
financial position. This has both direct and indirect impact on
all the major ratios like return on capital employed and
gearing.From the foregoing, the users of accounting
information must peruse the whole information contained in
the financial statement. The accounting policies adopted must
be understood so as to dictate how to compare one company
with another even in the same industry.

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Sunday Adebayo Alayemi: Choice of Accounting Policy: Effects on Analysis and Interpretation of Financial Statements

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