What Are Accounting Policies?

What Are Accounting Policies?

Let me explain what accounting policies are: they're the specific procedures that a company's management team implements to prepare its financial statements. These include accounting methods, measurement systems, and procedures for presenting disclosures. You should know that accounting policies differ from accounting principles because principles are the rules, and policies are how a company adheres to those rules.

Key Takeaways

Accounting policies are the procedures a company uses to prepare financial statements. Unlike accounting principles, which are rules, accounting policies are the standards for following those rules. These policies may be used to manipulate earnings legally. A company's choice in accounting policies will indicate whether management is aggressive or conservative in reporting its earnings. Accounting policies still need to adhere to generally accepted accounting principles (GAAP).

How Accounting Policies Are Used

Accounting policies are a set of standards that govern how you prepare your company's financial statements. You use these policies to handle complicated accounting practices such as depreciation methods, recognition of goodwill, preparation of research and development (R&D) costs, inventory valuation, and the consolidation of financial accounts. These policies can differ from one company to another, but all must conform to generally accepted accounting principles (GAAP) and/or international financial reporting standards (IFRS).

Think of accounting principles as a framework in which your company operates. However, the framework is somewhat flexible, and your management team can choose specific accounting policies that are advantageous to the financial reporting of the company. Because accounting principles are lenient at times, the specific policies of a company are very important.

Looking into a company's accounting policies can signal whether management is conservative or aggressive when reporting earnings. As an investor, you should take this into account when reviewing earnings reports to assess the quality of earnings. Also, external auditors hired to review a company's financial statements should check the company's policies to ensure they conform to GAAP.

Important Note

Company management can select accounting policies that are advantageous to their own financial reporting, such as selecting a particular inventory valuation method.

Example of an Accounting Policy

Accounting policies can be used to legally manipulate earnings. For example, in the United States, companies are allowed to value inventory using the average cost, first in first out (FIFO), or last in first out (LIFO) methods of accounting. Under the average cost method, when you sell a product, the weighted average cost of all inventory produced or acquired in the accounting period determines the cost of goods sold (COGS). Under the FIFO method, the cost of the inventory produced or acquired first is considered sold first. Under the LIFO method, the cost of the inventory produced last is considered sold first.

In periods of rising inventory prices, you can use these accounting policies to increase or decrease earnings. For instance, imagine a company in the manufacturing industry buys inventory at $10 per unit for the first half of the month and $12 per unit for the second half. The company purchases a total of 10 units at $10 and 10 units at $12, and sells 15 units for the entire month.

If the company uses FIFO, its cost of goods sold is: (10 x $10) + (5 x $12) = $160. If it uses average cost, it's: (15 x $11) = $165. If it uses LIFO, it's: (10 x $12) + (5 x $10) = $170. In the US, where companies can choose between FIFO and LIFO, a company wishing to maximize profits will use FIFO in periods of rising prices to minimize COGS and increase earnings. A company wishing to lower taxable income will use LIFO if prices are rising to increase COGS and decrease earnings.

What Is the Difference Between Accounting Policies and Principles?

While an accounting principle is the standardized rule set forth by a governing body, an accounting policy is the method or guideline you use as management to adhere to the rule and generate financial statements. In the United States, generally accepted accounting principles (GAAP) are the accounting standards accepted by the Securities and Exchange Commission (SEC). Certain accounting principles allow for management discretion, and that's where accounting policies come into play.

What Are Some Examples of Accounting Policies?

Accounting policies appear in a business when accounting principles allow leeway in how the rules are applied to a situation. Situations that involve management discretion include valuation of inventory, valuation of investments, valuation of fixed assets, depreciation methods, costs of R&D, and translation of foreign currency.

What Is the Difference Between Conservative and Aggressive Accounting?

Conservative accounting uses accounting policies that result in lower revenue and/or higher expenses. On the other hand, aggressive accounting uses policies that tend to increase revenue and/or reduce expenses. If you use conservative accounting policies, you'll have lower earnings in the current year, while aggressive policies will show better financial performance in the current year. Conservative policies tend toward better financial performance in the long run, while aggressive ones tend to lead to a decline over the long run.

The Bottom Line

Accounting policies are different from accounting principles, which are the accounting rules to which all accounting policies must conform. As a company's management team, you can choose specific accounting policies that are advantageous to the firm's financial reporting. You might use either conservative or aggressive accounting policies, which will determine how the company's financial performance appears in a given year.