What Are Accounting Policies and How Are They Used? With Examples
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What Are Accounting Policies?
Accounting policies are the specific 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.
Key Takeaways
- Accounting policies are procedures that a company uses to prepare financial statements.
- Unlike accounting principles, which are rules, accounting policies are the standards for following those rules.
- Accounting 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 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.
Important
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, 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 a company sells a product, the weighted average cost of all inventory produced or acquired in the accounting period is used to determine the cost of goods sold (COGS). 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. Under the LIFO method, when a product is sold, the cost of the inventory produced last is considered to be sold.
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.
If the company uses FIFO, its cost of goods sold is: (10 x $10) + (5 x $12) = $160. If it uses average cost, its cost of goods sold is: (15 x $11) = $165. If it uses LIFO, its cost of goods sold is: (10 x $12) + (5 x $10) = $170. It is therefore advantageous to use the FIFO method in periods of rising prices in order to minimize the cost of goods sold and increase 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 used by 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 is 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
- Translation of foreign currency
What Is the Difference Between Conservative and Aggressive Accounting?
Conservative accounting uses accounting policies that tend to understate revenue and/or overstate expenses. On the other hand, aggressive accounting uses policies that tend to overstate revenue and/or understate expenses.
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.
The Bottom Line
Accounting policies are different from accounting principles, which are the accounting rules to which all accounting policies must conform. A company’s management team can choose specific accounting policies that are advantageous to the firm’s financial reporting. The team might use either conservative or aggressive accounting policies, which will determine how a company’s financial performance appears in a given year.
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