What Are Accounting Policies?
The rules and practices established by an organization’s management for producing financial reports are known as “accounting policies.” Methods of accounting, systems of measuring, and techniques for making disclosures are all part of this category. A company’s accounting policies are its method of following generally accepted accounting principles, as opposed to the principles themselves.
How Accounting Policies Are Used
A company’s accounting policies are the rules its financial statements must abide by. Depreciation techniques, goodwill recognition, R&D cost preparation, inventory value, and financial account consolidation are just some of the more complex accounting procedures that may be addressed with the help of these rules. While specific accounting rules may vary from one organization to the next, it is important to note that all policies must align with GAAP and IFRS.
One way to look at accounting principles is as guidelines for running a business. However, there is considerable leeway within the framework, so an organization’s management may pick and choose the accounting standards that work best for their particular financial reporting needs. Accounting principles may be flexible. Thus, a company’s policies should be carefully considered.
Management’s conservatism or boldness in reporting results might be inferred from examining a company’s accounting procedures. Investors need to remember this when evaluating the credibility of earnings reports. A corporation’s policies should be checked for compliance with GAAP by the external auditors employed to analyze the company’s financial statements.
Example of an Accounting Policy
Earnings may be artificially inflated within the law by using accounting rules. For example, businesses may choose to calculate the value of their stock using either the average cost, FIFO, or LIFO accounting systems. The cost of goods sold (COGS) is calculated using the average cost technique, which considers the cost of all inventory manufactured or bought during the accounting period. The first-in, first-out (FIFO) inventory cost approach treats sold as the cost of goods generated or bought first. The LIFO accounting approach considers the cost of the inventory generated most recently to equal the cost of the product sold.
A corporation may boost or reduce profits depending on how it uses these accounting procedures when increasing inventory prices. A manufacturer, for instance, would pay $10 per unit for inventory in the first half of the month and $12 in the second. Ultimately, the business buys ten units at $10 and sells ten units at $12 for a total monthly purchase and sale of 15 units.
The FIFO method yields a COGS of $160 (10 x $10 + 5 x $12). Assuming an average cost of $11 per unit, the company’s sales price would be $165. Ten times $12 plus 5 times $10 equals $170, which is the cost of goods sold if LIFO is used. Therefore, in times of increasing prices, FIFO is preferable since it reduces the cost of items supplied and maximizes profits.
What Is the Difference Between Accounting Policies and Principles?
Accounting policies are the management’s methods and guidelines for following generally accepted accounting principles and producing reliable financial statements.
The Securities and Exchange Commission (SEC) recognizes only the accounting rules known as generally accepted accounting principles (GAAP) in the United States. There is room for managerial judgment in applying certain accounting rules; this is where accounting policies come in.
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
- Translation of foreign currency
What Is the Difference Between Conservative and Aggressive Accounting?
In conservative accounting, income and costs are more likely to be understated than they are to be overstated. However, aggressive accounting practices include things like padding sales and hiding costs.
The current year’s profits for a firm that uses cautious accounting rules will be lower than those of a company that uses aggressive accounting procedures. Financial performance will likely improve with more conservative accounting practices, whereas it will most likely worsen with more aggressive accounting methods.
Summary
- A company’s financial statements are generated using the rules and practices it has established for accounting.
- Accounting policies are the guidelines for applying accounting concepts instead of the principles themselves.
- Earnings may be artificially inflated within the law by using accounting rules.
- If management is aggressive or cautious with the company’s profits, it will show in its accounting procedures.
- Generally Accepted Accounting Principles (GAAP) must still be followed by accountants.
Accounting principles, the norms to which all accounting policies must adhere, are distinct from accounting policies. The management team might select Accounting regulations that benefit a company’s financial reporting. The team’s choice of accounting procedures, which may range from cautious to aggressive, will affect the reported financial success of the organization for a particular year.
