Accounting Policies: Definition, Importance & Examples

Accounting policies are the rules used by an entity to ensure that transactions are recorded properly and financial statements produced correctly. These policies ensure that accounting activities are handled consistently over time. They are also needed to ensure that an organization follows the applicable accounting framework, such as GAAP or IFRS. Businesses may also choose to adopt conservative or aggressive methods of accounting. A conservative policy means that the company is more likely to adhere to the accounting rules set out by GAAP or IFRS.

  1. Implementing accounting policies involves integrating them into the day-to-day operations of the business.
  2. Under the FIFO inventory cost method, when a company sells a product, the cost of the inventory produced or acquired first is considered to be sold.
  3. The Securities and Exchange Commission (SEC), the U.S. government agency responsible for protecting investors and maintaining order in the securities markets, has expressed interest in transitioning to IFRS.
  4. Here are a few controversial strategies companies adopt to make themselves more attractive to investors.

For cash accounting, revenue and expenses are recorded as they are received and paid, and transactions are only recorded when cash is spent or received. For example, in cash accounting, a sale is recorded when the payment is received, and an expense is recorded only when a bill is paid. However, if a business generates over $5 million in sales for the year, it must choose the accrual accounting method, according to the Internal Revenue Service. The very purpose behind giving a statement of accounting policies is to encourage better understanding of the financial statements.

Governmental Accounting Standards Board

These rules make it easier to examine financial data by standardizing the terms and methods that accountants must use. Under U.S. GAAP, the historical cost principle is a fundamental accounting principle. Even if their value has risen over time, their historical cost is reported on the balance sheet.

Some accounting policies and practices indirectly impact the cash flow statement. Reporting units typically represent distinct business lines, geographic units, or subsidiaries. The definition of the reporting unit is crucial and affects the financial statements accordingly. The depreciation accounting policy needs to spell out the depreciation method accounting policies meaning to be applied, the rate of depreciation, the disposal process, and the capitalization of expenses. Still, all these policies must conform to one of the two standards – Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). These are standards created for ethical and accurate financial reporting.

Accounting policies are rules and guidelines that are selected by a company for use in preparing and presenting its financial statements. Accounting policies are important, as they set a framework, which all companies follow, and provide comparable and consistent standard financial statements across years and relative to other companies. Accounting policy choices may be within the allowances approved by the accounting standards, but they can significantly change the numbers on the financial statements. For example, different ways to calculate depreciation and inventory costs will give you very different values. A company using conservative accounting policies will have lower earnings in the current year, while a company using aggressive accounting policies will show better financial performance in the current year. Conservative accounting policies will tend toward better financial performance in the long run, while aggressive accounting policies tend to lead to a decline in financial performance over the long run.

Disclosure is crucial and forms the basis for selecting your company’s accounting policies. Accounting provides information for all these purposes through the maintenance of data, the analysis and interpretation of these data, and the preparation of various kinds of reports. According to this principle, the financial statements should convey information and not conceal it.

Accounting Standard 1: Disclosure of Accounting Policies

An example would be translating a parent company’s foreign subsidiaries’ financial results into the functional currency. As a result, the company must alter its accounting records to reflect the difference. All of the policies in the company are very informative; therefore, management at all levels has to understand and need to train their staff to understand as well. Therefore, management at all levels has to understand and needs to train their staff to understand as well. In October 2018 the Board issued Definition of Material (Amendments to IAS 1 and IAS 8). Our Standards are developed by our two standard-setting boards, the International Accounting Standards Board (IASB) and International Sustainability Standards Board (ISSB).

Importance of Accounting Policies

The method chosen by a company to evaluate its inventory affects its cost of goods sold (COGS) and directly impacts its gross profit. Inventory valuation helps calculate the cost of goods sold and the cost of the unsold inventory and thus affects the profitability of your business. Generally, accounting policies can be categorized into the following types. The nature of policies shall be such that they give a true and fair view of the financial affairs of the business. Also, this shall be applied with consistency from one year to another so that uniformity is maintained. Accounting information can be developed for any kind of organization, not just for privately owned, profit-seeking businesses.

On the other hand, aggressive accounting uses policies that tend to overstate revenue and/or understate expenses. Revenue is the gross inflow of cash and receivables of an enterprise from the sale of goods of services or the yielding of any interest, royalties, and dividends. As per this consideration, the accounting treatment and presentation of transactions and events in the financial statements must be governed by their substance. There is no standardized list of accounting principles applicable to varied circumstances experienced by different enterprises. The information on financial statements should be complete so that nothing is misleading. With this intention, important partners or clients will be aware of relevant information concerning your company.

Expense recognition policies

One of the most important differences between IFRS and GAAP is their inventory treatment. IFRS does not consider using the last-in, first-out (LIFO) inventory accounting method. IFRS Accounting Standards are, in effect, a global accounting language—companies in more than 140 jurisdictions are required to use them when reporting on their financial health. A conservative policy may make a company appear more reliable to outsiders.

In periods of rising inventory prices, a company can use these accounting policies to increase or decrease its earnings. For example, 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 of the month. The company ends up purchasing a total of 10 units at $10 and 10 units at $12 and sells a total of 15 units for the entire month. In addition to being relevant and reliable, accounting information should be comparable and consistent. Comparability refers to the ability to make relevant comparisons between two or more companies in the same industry at a point in time. Consistency refers to the ability to make relevant comparisons within the same company over a period of time.

Good accounting policies ensure compliance with accounting standards and regulatory requirements. By adhering to recognized standards, your company can reduce the risk of regulatory penalties, fines, or legal actions resulting from non-compliance. For example, a revenue recognition policy will affect the timing of recognizing the revenue recorded as an asset. Procedures of inventory valuation, depreciation, lease accounting, or valuation of investments will all alter the recognition and measurement of assets, liability, and equity.

This policy outlines the method used (straight-line) for depreciating assets and the periodic review to ensure accuracy and relevance. If auditors or investors believe management is falsifying profitability or shifting costs, aggressive accounting procedures might raise red flags. GAAP requires several accounting conventions to ensure that companies report their financials as accurately as possible.

Accounting practice is the process and activity of recording the day-to-day financial operations of a business entity. Accounting practice is necessary to produce the legally required annual financial statements of a company. There are different accounting methods that companies can choose to use, and there are principles that companies must abide by. Generally accepted accounting principles (GAAP) refer to a common set of accounting principles, standards, and procedures issued by the Financial Accounting Standards Board (FASB). Public companies in the United States must follow GAAP when their accountants compile their financial statements. Accounting policies define the company’s rules while creating its financial statements.

If the average cost method is used, the weighted average cost of all inventory in the accounting period determines the cost of goods sold (COGS). The commonly accepted accounting principles may vary regionally and in different companies. The two most commonly followed accounting principles are Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS). Accounting principles are the main accounting rules, and accounting policies are how a company uses the rules. They also draw on established best practices governing cost, disclosure, matching, revenue recognition, professional judgment, and conservatism.

Depending on the method used, revenue can be recognized at different times. For example, if you use the accrual basis, sales made on credit are also recognized as revenue. In contrast, if you use a cash basis, your company will only record revenue when cash is received.