What are Accounting Policies? Types, Examples & Significance of Accounting Policies

What are Accounting Policies?

Purpose of Accounting Policies

1. Consistency: As companies determine the accounting policies to work with, it will ensure consistency across financial reports and make it easier to conduct analysis.
2. Aid in Decision-Making: Standard accounting policies ensure transparency across financial reports which helps stakeholders and investors make informed decisions.
3. Comply with Legal Requirements: By using standard accounting policies companies ensure they meet regulatory and legal requirements and reduce the chances of facing fines and penalties.
4. Ensure Comparability Across Companies: Standardized accounting policies can make financial statements easily comparable across companies in the same sector which can make the analysis process simpler for investors and lenders.
5. Investor Confidence: Investors are more likely to work with companies that implement recognized accounting policies and are transparent about their financial reporting practices.

Accounting Policies and Their Application by Companies

1. Valuation of Fixed Assets: Companies must use specific policies for valuing their fixed assets like buildings and machinery. Under the historical cost policy, assets would be recorded at their purchase prices or they could use fair value dictates that the value of assets should routinely be adjusted to reflect current market prices.
2. Depreciation and Inventory Policies: All companies have to decide on a depreciation method for their fixed assets such as straight-line or declining. For inventory valuation methods such as FIFO or LIFO should be determined.
3. Valuation of Investments: The manner in which the valuation of investments is carried out, influences the reporting of bottom-line profit or loss, thus specific accounting policies must be defined for the same.
4. Revenue Recognition: Cash or accrual basis - companies must decide when they will recognize revenue. The decision affects when the revenue will be stated in the income statement.
5. Research and Development (R&D) Costs: A company that spends a lot on R&D should figure out whether it wants to capitalize R&D costs as an asset or expense them straight away.
6. Translation of Foreign Currency Items: Organizations dealing with multiple currencies must decide how to convert those transactions into their reporting currency - a decision that can impact the preparation of income and balance sheet.

Types of Accounting Policies

1. Revenue Recognition
2. Expense Recognition
3. Inventory Valuation
4. Depreciation
5. Asset Valuation
6. Goodwill Impairment
7. Lease Accounting

Revenue Recognition

• Accrual Basis: Revenue is recorded when the company earns it, not when it receives cash. It uses the matching principle which requires recording revenues and the related expenses in the same period.
• Cash Basis: Revenue is recorded when actual payment is received. The method is easy but rarely used as it can provide an inaccurate picture of a company’s financial performance when the payments are delayed.

Expense Recognition

Inventory Valuation

• First In, First Out (FIFO): With FIFO, the first items added to inventory are assumed to be the first sold. This means in periods of high prices, the company may report COGS and higher earnings.
• Last In, First Out (LIFO): With LIFO, the latest items added to inventory are assumed to be sold first. This means in periods of low prices, the company may report higher COGS and lower earnings.
• Weighted Average Cost: The method divides the total cost of all goods available by the number of units available for sale through the period. 

Depreciation

• Straight-Line Depreciation: The same depreciation expense is allocated to every year of the useful life.
• Declining Balance Depreciation: A fixed percentage is applied to the book value of an asset, thus increasing the depreciation amount in the initial years of the asset’s life.
• Units of Production Depreciation: Depreciation is determined not by time, but by the actual usage or output of the asset.

Asset Valuation

• Historical Cost: The original purchase price of the asset is used for recording.
• Fair Value: The current market price of the asset is used for recording.

Goodwill Impairment

Lease Accounting

• Operating Leases: They are expensed as rent with lease payments flowing through the income statement as operating expenses.
• Finance Leases:  These are treated as if the company owns the asset it has leased. It records the asset on its balance sheet and expenses the interest and the depreciation of the asset over the lease term.

Impact of Accounting Policies on Financial Statements

1. Balance Sheet:
   • Accounting policies for assets, depreciation, and inventory valuation impact the reported values of a company’s net assets/debt. For instance, valuing assets at historical cost rather than fair value can make a company’s assets look less valuable, which would impact key financial metrics.
2. Income Statement:
   • Accounting choices regarding the recognition of revenue and expense matching can impact the time at which revenue and expenses are recognized.  For example, accelerated revenue recognition can lead to overstated earnings.
3. Cash Flow Statement:
   •  While accounting policies don’t directly impact cash flows, they affect how these are represented in the financial statements. For example, an aggressive accrual basis method can show higher cash flow from operations.
4. Disclosure in Financial Statements:
   • Financial statements should disclose the major accounting policies used by the company. This information allows stakeholders to ascertain how particular financial numbers have been calculated, and whether any change in policy may have affected the outcomes.

Conclusion

FAQs

1. How do accounting policies differ across industries?Accounting policies differ across industries depending on the nature of business transactions and operations. For instance, an IT services company will focus on revenue recognition policies for long-term contracts. On the other hand, manufacturing firms may focus on inventory valuation and depreciation. This allows financial statements to reflect the nature of the business.
2. What is the role of accounting policies in mergers and acquisitions?The buyer and seller need to agree on which policies will be applied to the accounts, so they can understand the value of the assets, liabilities and the entire business in general during mergers and acquisitions. Differences in policies – such as how inventory is valued or how revenues are recognized – can substantially impact the presentation of a company’s financials, which in turn impacts the terms of a deal.
3. How do accounting policies affect a company's tax obligations?A company’s tax payments are influenced by the accounting policies they employ. For example, a company using the LIFO method can inflate the COGS and reduce taxable income in periods of downward trends. Choosing to depreciate an asset using a more conservative method results in tax benefits being deferred to subsequent periods. The right policies and their implementation can help companies optimize their tax strategies.
4. What are the consequences of non-compliance with accounting policies?Non-compliance with accounting policies can lead to sanctions or penalties, reputational damage, regulatory probing, unreliable financial statements that cannot be quoted or used for capital raising, investigations around tax reporting, and fines.
5. How do external auditors evaluate a company’s accounting policies?External auditors review a company's accounting policies to confirm they comply with the applicable accounting standards and have been implemented consistently. Auditors may review the appropriateness of these policies for the particular company’s circumstances. If the policies are too aggressive or vary from industry standards, the same would be highlighted in their report.
6. How often should a company review or update its accounting policies?A company should review their accounting policies on an annual basis, at a minimum. The company should also conduct a review whenever there has been a change in accounting standards or business operations or regulatory requirements. If a company goes international or adds a line of business it may need to update its accounting policies to reflect this change in operations. 
7. What is the significance of documenting accounting policies in a manual?Accounting policies being recorded in manuals can act as a guide for the accounting department. The department can refer to the policies whenever there's any confusion or ambiguity regarding any financial transaction that needs to be recorded. It can be used to train new recruits. It also enables companies to meet compliance requirements during audits.
8. How do changes in accounting policies affect financial comparability?The comparability of financial statements can change depending on the company’s adoption of different accounting policies. For example, switching from a straight-line to a declining depreciation method changes how a company values assets, thereby altering year-to-year comparisons of earnings. Companies are required to disclose such changes prior to the period's financials for the sake of consistent comparability.
9. Is it possible for a company to manipulate financial results with the use of accounting policies?It is expected that companies will follow standard accounting standards, but they can exercise judgment in selecting their accounting policies. For example, a company might use an aggressive revenue recognition policy at the expense of lower reported earnings in future periods. Regulators and investors typically check for such policies to ensure companies provide a true picture of their financial health.
10. What external factors can prompt changes to accounting policies?