What Are Accounting Policies?
An accounting policy is a set of instructions or guidelines that explain how a company should calculate its revenue, expenses, and income from the sales of goods and services.
An accounting policy exists when a company establishes general standards and procedures to prepare and present financial statements. These guidelines help presenters of financial statements provide investors, auditors, clients, and other stakeholders with an understanding of the company’s financial records. Often, an accounting policy establishes a standard method used to account for income, expenses, revenues, and assets.
How Are Accounting Policies Used?
Accounting policies are intended to explain why a company’s statements of financial position differ from financial statements prepared by independent auditors assigned to that company. Accounting policies are rules that a company or person follows to manage its financial affairs following accounting principles and generally accepted accounting principles (GAAP). In general, an accounting policy states how a company’s manager determines their internal procedures for preparing the statements of the financial position given to auditors. It defines each stage of preparation from the initial gathering of information through presentation and revision.
The purpose of an accounting policy is to ensure that there is no confusion concerning the facts used in the communication of financial information. Accordingly, an accounting policy must establish clearly why a statement of financial position differs from statements prepared by independent auditors assigned to that company.
Accounting policies are guidelines a company uses to understand and create financial statements. These policies are how the company communicates its accounting information, which ultimately allows investors to understand what a given company is reporting. Accounting policies might also include management’s estimates or financial records.
Example of an Accounting Policy
The accounting policies in use can help a company to manipulate its earnings legally. For example, the three acceptable methods for valuing inventory are the average cost method, the first in first out method, and the last in first out method. Ultimately, the most commonly used cost of goods sold methodology is under the average cost method, which determines the cost of goods sold by averaging all inventory produced or acquired in the accounting period.
Under the FIFO method, when any inventory is sold, the cost of the product in stock first is deducted. Under the LIFO method, the oldest cost of the product is used to calculate taxable income.
To illustrate, assume that ACME Manufacturing buys inventory at $10 per unit for the first half of a given month and $12 per unit for the second half of a given month. At the end of the month, ACME will have purchased 10 units at $10 per unit and 10 units at $12 per unit. The company sold 15 units for the entire month.
If a company uses the first-in, first-out (FIFO) inventory method, its cost is $160. If it uses the average cost method, its cost of goods sold is $165. If it uses the last-in, first-out (LIFO) method, its cost of goods sold is $170. In other words, it is more advantageous to use FIFO in rising prices as opposed to average cost.
IFRS vs. GAAP
International Financial Reporting Standards (IFRS) and the Generally Accepted Accounting Principles (GAAP) are similar in many ways, but they also have distinct differences. IFRS is more principles-based, while GAAP is more rules-based.
The IFRS was developed by the International Accounting Standards Board and is used by several countries for reporting and accounting, while the GAAP, on the other hand, is used in the United States to report financial transactions and prepare financial statements under certain circumstances.
Conservative vs. Aggressive Policies
Conservative accounting policies create an artificially low picture of the company’s actual financial performance and show an even better financial performance in the next year. This is much more sustainable and shows improvement over time, making it a positive signal for investors.
Aggressive accounting policies make a company look like it is performing better than it is. It makes companies appear profitable in the short term. Still, the effects of those policies will show themselves in future years, when a company’s actual performance has fallen below its aggressive accounting.
Aggressive accounting policies may cause an erratic, unpredictable trajectory with the company’s performance.
Importance of Accounting Policies
Financial accounting policies are essential to companies for the preparation of accurate financial statements. As well, these policies are critically important to investors and tax authorities.
- Government retaining a hold on financial statements – All companies must prepare financial statements using GAAP or IFRS standards. This will ensure government oversight and protect the interests of stakeholders.
- Proper framework – The purpose of accounting policies is to provide a company with a policy framework that allows financial statements to adhere to standardized formatting throughout the industry.
- Providing advantage to investors – The company’s financial statements are based on generally accepted accounting principles. This helps investors understand its financial standing and compare them with other companies in the same industry.
- Disclosure – The accounting policies must be disclosed to the shareholders of any company so the disclosures can be classified as adequate and no false financial reports are provided.