What Are Accounting Policies?
Accounting policies are the specific principles and procedures implemented by a company’s management team that are used to prepare its financial statements. These include any accounting methods, measurement systems, and procedures for presenting disclosures. Accounting policies differ from accounting principles in that the principles are the accounting rules and the policies are a company’s way of adhering to those rules.
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.
International Accounting Standard 8 (IAS 8) defines accounting policies as “the specific principles, bases, conventions, rules and practices applied by an entity in preparing and presenting financial statements”.
Accounting policies are included in the notes that accompany the financial statements of a business. Examples of these policies are:
- How the business recognizes revenue
- How the business recognizes depreciation
- Which cost flow method is used to recognize inventory
- Which research and developments costs are capitalized and which are expensed
The aggressiveness or conservativeness of a firm’s accounting policies provides an indicator of how the management team uses accounting to pursue higher “book” profits. Thus, investors should peruse all published policies of an entity to see if the financial statements it produces have the potential to reflect an aggressive view of its results and financial condition.
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.
Accounting policies are the set rules and conventions that are provided by some national or international committee of accountancy for the entities to follow while organizing their monetary statements. The entities have to follow these specific conventions and principles in the preparation and presentation of their final accounts. The reason for setting these conventions is the consistency in the financial statements of different entities and prohibiting the use of misleading policies to coerce the users of financial statements.
How Accounting Policies Are Used
Accounting policies are a set of standards that govern how a company prepares its financial statements. These policies are used to deal specifically with 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 may differ from company to company, but all accounting policies are required to conform to generally accepted accounting principles (GAAP) and/or international financial reporting standards (IFRS).
Accounting principles can be thought of as a framework in which a company is expected to operate. However, the framework is somewhat flexible, and a company’s 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. This should be taken into account by investors when reviewing earnings reports to assess the quality of earnings. Also, external auditors who are hired to review a company’s financial statements should review the company’s policies to ensure they conform to GAAP.
Significance of Accounting Policies
They are significant for the following reasons –
- Proper framework: To articulate the financial affairs of the company, it needs to prepare financial statements. And if the financial statements are just prepared without any guidance, there would be no coherence within them. They help find out the coherence between financial statements. Accounting policy also offers a solid framework to follow so that the company may adhere to the right structure and prepare its financial statements.
- Disclosure: It’s important that a company discloses what accounting policy they have been following. Since accounting standards let any item be represented in many ways, proper disclosure of the accounting policy is important.
- Providing advantage to investors: If the companies mention the accounting policy they used to produce the financial statements, it will also help the investors. By stating the accounting policy the companies ensure that they have maintained coherence while producing the financial statements. This coherence helps the investors look at the financial statements and compare them with other companies from similar and different industries.
- The government can keep a hold on the company’s financial statements: Since all the financial statements should be prepared as per the accounting policy, the companies always follow a proper structure. These companies also need to keep in mind that they can only follow the accounting policy that is made as per GAAP or IFRS. Thus, the government can have a direct hold on the company’s financial statements and the government can protect the interest of the investors.
Selection of Accounting policies
Companies work on certain key points for selecting accounting policies. Companies choose the following considerations as a basis of these policies.
Precise and Accurate Presentation
Accounting policies should clearly convey the account’s information. Rather than making unnecessary adjustments, the policies must present every piece of information as genuine and simple.
For example, a company owns resources are assets. At first, assets add to the expense list. Afterward, its future potential is measured.
Applying the accuracy criterion, the firm would make an inventory list. It would include expenses used on the asset during a period and the services consumed during the period.
There is only one associated limitation. A firm can’t precisely measure an asset’s usability and the remaining potential it holds.
In choosing among generally accepted principles, a firm’s priority goes to policies that have conservative measures of net income. As business offers many uncertainties, a conservative approach towards benefits is always preferable.
Accordingly, Conservatism implies that policies form a major part of accounting. They must recognize expenses as fast as possible.
In addition, they must delay revenues as long as applicable. This method minimizes cumulative reported earnings.
Working in the opposite direction to Conservatism, this technique supports maximizing cumulative reported earnings. That is, policies must recognize revenues as quickly as possible.
And to delay expenses as long as possible. Use of this accounting process is that a firm generates profits. The report should be a favorable one. It must showcase a firm’s growth.
Another criterion for selecting accounting policies is Income Smoothing. As the name suggests, income smoothing works to make the flow of income easy. It suggests to first analyze the earnings.
Then, minimize fluctuations in earnings. This will decrease risks linked with invested shares. In return, the chances of earnings will increase. This criterion also suggests net income, revenues and expenses to be smoothed.
So, basically, this policy works on taking shorter steps leading to an ultimate goal i.e. raising profits.
Accounting Policies – Conservative vs Aggressive
Typically firms operate within the periphery of two extremes in regards to accounting policy.
Either a firm follows an aggressive approach or a conservative approach.
No matter what approach a company follows, it needs to reflect the same in its accounting and in the way the accounting policies are followed in preparing the financial statements.
The same will also affect profits. An aggressive approach may end up generating more/fewer book profits. And a conservative approach may do the same. The company should stick to one specific approach so that the coherence is maintained.
If the company changes its approach from aggressive to conservative or from conservative to aggressive, it should be mentioned and also why it has been changing its approach for the protection of the interests of the investors.
According to International Accounting Standards 8, accounting policies are conventions, rules, procedures, principles, bases, and even practices. That means the whole framework of accounting standards in preparing and presenting the financial statements of the company can be called as accounting policies.
The accounting approach to using the accounting policy shouldn’t be based on a single transaction or event or condition. The accounting policy should be used by keeping the big picture in mind and by thinking about the preparation of financial statements and also how these financial statements would be represented to the investors.
Types and example of accounting policies
Policies are related to revenue recognition and measuring. This normally includes the criteria in which the company could recognize its revenue and amount to be recognized.
For example, the revenue is recognized only when the goods are receipt by the customer. In this case, the evidence to support revenue recognition in the Financial Statement would be a delivery note that signed receipted by the customers.
Accounting policies related to expenses including the general expenses and specific expenses like depreciation. For general expenses, for example, training is recognized only when the training incurred o not at the time cash advance for training.
The policies for expenses normally link to liabilities both recognition and measurement. Account policies for depreciation would be the nature of expenses that should or should not capitalize, the depreciation rate as well as the process of disposal assets.
Another simple example of accounting policy is about inventories. Those policies will include what method the company uses to measure its inventories. It could be a weighted average or FIFO. The way how to entity control and manage its inventories.
For example, by using a perpetual inventories system or periodic inventories system. If the perpetual is use, inventories have to could continuously and randomly.
All of the policies in the company are very information therefore, management at all level have to understand and need to train their staff to understand as well.
Or example, by using a perpetual inventories system or periodic inventories system. If the perpetual is use, inventories have to could continuously and randomly. All of the policies in the company are very information therefore, management at all level have to understand and need to train their staff to understand as well.
In most of the case, the company has the induction program at the first time new employee come to work for the company and such program help the employee to be aware and understand about what are the important policies and Accounting Policies in the company, and what they need to do to avoid misconduct.
Restrictions on Selecting Accounting Principles
There are a number of policies for a business to try and adapt. This does not necessarily mean that a firm can choose a policy whenever it likes. Also, it cannot discard a policy when it doesn’t suit the business anymore.
It has to obey certain rules. Generally, a firm compiles a set of policies and as a permanent set. Whereas, a secondary set is prepared to cover other requirements.
Even if a company separates financial reports and income tax reports, the practices are legal. The government organization just wants reports related to a firm clear and understandable.
The reports must be open to examination. Financial statements should disclose the firm’s owned assets. It should not hide any previous dues that may harm in the future.
Accounting policies are strict rules and a company must follow them. After all, these policies benefit everyone including the firm. If you buy shares from a trusted firm and it vanishes from the view in days, how would you feel?
Similarly, if you are investing in a business, make sure you are giving your best to receive the best. Accounting policies help to give true meaning to a business.
Therefore, to maintain the decorum of business standards, apply necessary policies in your business. Also, make them open to concerned authorities. This will help your business grow.