Accounting Policies Definition

Accounting policies, methods, processes, or procedures are the specific steps taken by a business to create its financial statements while adhering to certain policies. They provide guidance on how transactions should be recorded, how assets and liabilities should be valued, and how income and expenses should be recognized. Accounting policies are generally set out or created in a company's accounting manual or policy handbook.

Role of Accounting Policies

Role in Financial Reporting

The preparation of financial statements in conformity with generally accepted accounting principles (GAAP) or other pertinent accounting standards is one of the main purposes of accounting policies. By establishing consistent principles, practices, and procedures, accounting policies help ensure that financial information is accurate, reliable, and comparable across companies and over time.

Accounting policies also help companies comply with regulatory requirements, such as the Securities and Exchange Commission's (SEC) rules on financial reporting. Companies must disclose their accounting policies in their financial statements, which are subject to review and audit by external auditors to ensure compliance with applicable accounting standards.

Role in Decision-Making

Accounting policies also play a critical role in decision-making. By providing users of financial statements with a clear understanding of how financial information has been prepared, accounting policies enable them to make informed decisions about investing, lending, or other financial activities. Creditors can use financial statements to determine a company's creditworthiness and default risk, while investors can analyze a company's financial condition and future growth potential.

Accounting policies also help management make informed decisions about business operations. By establishing consistent principles for recording and measuring financial transactions, accounting policies provide management with a reliable basis for evaluating performance, identifying areas for improvement, and making strategic decisions.

Role in Compliance

In addition to their role in financial reporting and decision-making, accounting policies are also critical for ensuring compliance with laws and regulations. For instance, firms must set up and maintain internal controls over financial reporting, including accounting policies and processes, under the Sarbanes-Oxley Act (SOX).

Accounting procedures also assist businesses in observing tax laws and regulations, depending on the Internal Revenue Code (IRC). By establishing consistent principles for recognizing income, expenses, and other financial transactions, accounting policies enable companies to calculate their tax liability and file accurate tax returns.

Different Types of Accounting Policies

In this section, we will discuss the different types of accounting policies that companies may adopt. They are:

Revenue Recognition Policy

A revenue recognition policy is one of the most critical accounting policies, which defines when a company should recognize revenue from its sales of goods or services. Revenue recognition policies may vary based on the nature of the business, the types of products or services sold, and the terms of the contracts with customers.

Inventory Valuation Policy

The inventory valuation policy defines how a company values its inventory, such as using the FIFO (first-in, first-out) or LIFO (last-in, first-out) method. Both the value of inventory on the balance sheet and the cost of goods sold are impacted by this policy.

Depreciation Policy

A company's depreciation policy specifies the methods it will use to depreciate its fixed assets over time, such as straight-line depreciation or accelerated depreciation. The amount of depreciation expense recorded in the income statement and the carrying value of fixed assets on the balance sheet are both impacted by this policy.

Leasing Policy

Leasing policy defines how a company accounts for its leased assets, such as recognizing them as operating leases or finance leases. This policy impacts how assets and liabilities are listed on the balance sheet and how much leasing expense is recorded in the income statement.

Foreign Currency Translation Policy

Foreign currency translation policy defines how a company translates its foreign currency transactions and balances into its reporting currency. This policy impacts the amount of foreign exchange gain or loss recorded in the income statement and the carrying value of assets and liabilities on the balance sheet denominated in foreign currencies.

Capitalization Policy

Capitalization policy defines how a company determines whether to capitalize or expense costs related to the acquisition, development, or improvement of assets. This policy has an impact on the asset's carrying value on the balance sheet as well as the timing and quantity of expenses recorded in the income statement.

Pension Accounting Policy

A company's defined benefit pension plans are recorded according to its pension accounting policy. This policy affects the amount of pension expense recognized in the income statement and the carrying value of the pension liability or asset on the balance sheet.

Difference between GAAP and IFRS

The two sets of accounting standards known as IFRS (International Financial Reporting Standards) and GAAP (Generally Accepted Accounting Principles) specify the requirements for preparing and presenting financial statements. While GAAP and IFRS share many similarities, there are also significant differences between the two, particularly regarding accounting policies.

The way that GAAP and IFRS handle accounting policies is one of their main differences. GAAP is a rules-based system that provides specific guidance on accounting for certain transactions and events. In contrast, IFRS is a principles-based system, providing more general principles that must be applied flexibly to specific situations. As a result of these different approaches, there are often differences in the accounting policies used under GAAP and IFRS. For example, under GAAP, companies must use the last-in, first-out (LIFO) method for valuing inventory in certain circumstances. In contrast, under IFRS, companies are not allowed to use LIFO and must instead use the first-in, first-out (FIFO) or weighted average cost methods.

Another difference between GAAP and IFRS is the treatment of intangible assets. Under GAAP, intangible assets such as patents and trademarks are often recognized on the balance sheet and amortized over their useful lives. In contrast, under IFRS, intangible assets are only recognized if they meet specific requirements and are instead subject to impairment testing rather than being amortized. In summary, while GAAP and IFRS are used to guide accounting policies, they take different approaches. While IFRS is a concepts-based system that offers more basic principles, GAAP is a rules-based system that offers detailed guidelines. As a result, the accounting principles applied by each system frequently vary.

Accounting Policies - Conservative vs. Aggressive

As a firm prepares its financial accounts, it adheres to a set of precise principles, practices, and procedures known as accounting policies. Both conservative and aggressive policy stances on accounting policies are common.

Conservative accounting policies are characterized by a cautious approach to recognizing revenues and recording expenses. This approach is based on the principle of prudence, which requires companies to recognize losses and liabilities as soon as they are known but to only recognize gains and assets when certain. Under conservative accounting policies, companies tend to be more hesitant to recognize potential gains or revenues and are more likely to underestimate assets or overestimate liabilities.

Aggressive accounting policies, on the other hand, are characterized by a more optimistic approach to recognizing revenues and recording expenses. This approach is based on the assumption that future outcomes will be favorable, and therefore companies tend to recognize potential gains or revenues and underestimate liabilities or overestimate assets. Aggressive accounting practices may involve more arbitrary accounting decisions and procedures that are not always compliant with generally accepted accounting principles (GAAP) or international financial reporting standards (IFRS).

There are advantages and disadvantages to both conservative and aggressive accounting policies. Conservative policies tend to provide more accurate financial statements and can help avoid financial reporting scandals by understating assets and overestimating liabilities. However, they may also result in lower reported earnings, which can negatively affect a company's stock price and shareholder confidence. Aggressive policies, on the other hand, may result in higher reported earnings, which can boost a company's stock price and shareholder confidence. However, they can also lead to financial reporting scandals and regulatory scrutiny if they are not in compliance with GAAP or IFRS.

In practice, most companies use a combination of conservative and aggressive accounting policies, depending on their specific circumstances and the economic environment. The choice of accounting policies ultimately depends on the company's goals and the risk tolerance of its management team. Companies that prioritize transparency and accuracy in their financial reporting tend to lean toward conservative accounting policies, while companies that prioritize growth and seek to earn investor confidence may prefer aggressive accounting policies.

Accounting Policy Examples

Accounting policies become clear in a company when accounting principles allow for flexibility in how the rules are applied to a situation. The following situations call for managerial discretion:

• A valuation of the stock.
• Investment valuation.
• Assessment of fixed assets.
• Techniques for depreciation.
• R&D expenses.
• Conversion of foreign money.

As already discussed, all financial statements are prepared by following certain policies. Below, we discuss some practical examples that will help us understand how they are monitored:

1. Revenue Recognition

When revenue is earned and is either realized or realizable, it can be recognized by the company. However, some revenue might be in a form other than cash. The following requirements are often met or satisfied when earning revenue:

• There is convincing proof that an arrangement exists.
• The goods have been delivered, or the services have been provided.
• The price that the vendor charges the buyer is set or determinable.
• Collectability is reasonably assured.

The company typically considers the nature of its revenue transactions, the terms of its contracts, and its historical experience in recognizing revenue when assessing whether these criteria/ requirements have been met. Revenue is generally recognized net of discounts, returns, and allowances.

For example, a company that sells products would recognize revenue when it delivers the product to the customer, and the customer accepts the product. A company that provides services would recognize revenue when it has completed the services and the customer has been billed (or payment is reasonably assured).

2. R&D Expenses

In the context of accounting, Research and Development (R&D) expenses refer to the costs associated with discovering and developing new products, services, or technologies. As R&D is often a critical component of a company's growth and success, accounting policies related to R&D expenses are important to ensure accurate financial reporting.

Here are some examples of accounting policies related to R&D expenses:

• Capitalization of R&D costs: Some companies choose to capitalize certain R&D costs, meaning they are added to the company's balance sheet as assets and are depreciated over time. This policy is typically used when R&D costs related to the development of a product or technology will generate economic benefits in the future.
• Recognition of R&D tax credits: Some companies may be eligible for tax credits related to their R&D expenses. Accounting policies related to the recognition of these tax credits will impact the company's financial statements.
• Disclosure of R&D expenses: Companies are required to disclose their R&D expenses in their financial statements. Accounting policies related to the classification and presentation of these expenses can impact the reader's understanding of the company's financial performance and potential for future growth.
• Allocation of shared R&D costs: When multiple departments or business units contribute to R&D efforts, accounting policies related to the allocation of shared costs can impact how the expenses are reported in the financial statements.

Overall, accounting policies related to R&D expenses can have a significant impact on a company's financial reporting and can provide valuable information to investors and other stakeholders. It is important for companies to carefully consider their accounting policies related to R&D expenses and ensure they are in compliance with applicable accounting standards and regulations.

What is the difference between Accounting Policies and Principles?

Accounting policies and principles are related but distinct concepts in accounting.

Accounting principles, also known as Generally Accepted Accounting Principles (GAAP), refer to a set of standard guidelines and rules that govern the accounting process and financial reporting. These principles are used to ensure consistency, comparability, and accuracy in financial reporting across different companies and industries. Examples of accounting principles include the revenue recognition principle, matching principle, and historical cost principle.

On the other hand, accounting policies are the specific methods, procedures, and practices that a company uses to implement accounting principles in its financial reporting. Accounting policies can vary from company to company based on their unique circumstances and needs. Examples of accounting policies include the method of depreciation, inventory valuation method, and treatment of research and development costs.

In summary, accounting principles are the foundation of financial reporting, while accounting policies are the specific practices and procedures that companies use to implement those principles. Adhering to both accounting principles and policies is important for ensuring accurate and reliable financial reporting.

The Bottom Line

Accounting policies are different from accounting principles, which are the rules that all accounting policies must follow. A corporation's management team may use accounting procedures that are advantageous to the company's financial reporting. The team could use conservative or proactive accounting techniques, which will have an impact on how a company's financial performance is reported in a certain year.