What are Accounting Policies? Types and How are they Used

Introduction

“If your business was a play, accounting policies are the curtain raiser.”

Accounting policies are a company’s guidelines and procedures to record, prepare, and present its financial statements. These financial statements are submitted to the shareholders, investors, financial institutions, and other entities outside the company. 

Accounting policies provide a clear picture of your company’s finances. 

Drafting suitable accounting policies will provide a robust framework. Within this framework, you can churn out accurate and consistent financial statements to help in financial reporting.

Read More: Accounting Principles: A Comprehensive Guide 2023 – 2024

What are accounting policies?

Accounting policies are a company’s principles, practices, and methods  to prepare and present its financial statements. These policies provide a framework to recognize, measure, record, and disclose your company’s financial transactions. 

Accounting policies are essential for maintaining consistency and comparability in financial reporting. It allows investors and stakeholders a peek at the company’s financial position and assess its performance. 

Companies must:

• Choose accounting policies best suited for their business in compliance with accounting standards
• Consistently implement them
• Disclose them for transparency
• Communicate changes in the policies

It will help make your financial statements more meaningful.

Importance of accounting policies

Accounting policies are essential for the company, as it uses them to generate its financial statements. Additionally, it is also vital to the government and the investor. 

The following points justify the importance:

1. Role in financial reporting

• Accounting policies provide a proper framework for all accountants and management. It thus generates a standardized form of financial statements across the company.
• It provides consistency for comparing  the previous year’s performances or between peers and competitors. 
• They provide a ready reference for similar business scenarios your company may encounter at different times.
• They help maintain internal control by following standard procedures for similar transactions.

2. Role in disclosure

Disclosure is crucial and forms the basis for selecting your company’s accounting policies. You will have to disclose the accounting policies you follow. 

Accounting policies define how you would share information with investors and companies. Giving the business world a clear picture of the financial status of your company will make it more valuable and credible. 

3. Attracting investors

Accounting policies define the company’s ability to produce easy-to-understand and transparent financial statements. Analysts and investors looking at these clear financial statements would find the company more attractive and trustworthy. They will likely consider a long-term investment in your company. 

4. Government compliance

Companies follow the Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS) to prepare financial statements. 

Disclosure of accounting policies by the company to the government is mandatory. These disclosures form a part of the financial statements. This way, the government keeps a tab on the companies and protects the interests of the investors and stakeholders.

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Types of accounting policies

Different accounting policies encompass a wide range of practices for the various transactions of the company.

Generally, accounting policies can be categorized into the following types.

1. Revenue recognition policies

The revenue recognition policy guides the company on when to recognize the revenue, i.e., whether it is recognized at the point of sale, upon delivery, or over time. It also specifies the basis of measurement for the revenue, i.e., gross or net amount. 

Broadly, companies use the following three methods:

• Accrual basis: Revenue is recognized when it is earned, regardless of when payment is received. It is used for matching revenues with associated expenses. 
• Cash basis: This method recognizes revenue when cash is received. Smaller businesses often use it, and it is a more straightforward method.
• Installment sales method: Revenue is recognized over time as and when payments are received from the customer. It is applied when goods or services are delivered over an extended period. 

Impact on financial statements

The impact of revenue recognition policies is evident in the financial statements, especially on the income and balance sheets. 

• On the income statement, based on the policies used, reported revenue will vary, consequently changing the net income. If guidelines recognize revenue later, then short-term profitability will be affected. Consistent application of revenue recognition policies ensures that financial statements are comparable over time. 
• On the balance sheet, the policies will impact the accounts receivable balance. With unearned revenue reported, like in the subscription model, the liability section of the balance sheet is affected.

2. Expense recognition policies

Expense recognition occurs when a company incurs expenses and recognizes them along with the associated revenues. The expense recognition policies outline a set of procedures for expense recognition.

Matching principle

The expense recognition policy is embedded in the matching principle by the GAAP. 

The Matching Principle is an accounting concept that requires companies to report expenses simultaneously when the related revenues are generated. Revenues and expenses are matched on the income statement for a year, quarter, or month.

Businesses that follow accrual accounting implement the matching principle. The matching principle helps give a smooth, normalized income statement where revenues and expenses are tied together. By matching them together, the investors get a better sense of the economics of the business.

Depreciation and amortization methods

The choice of depreciation and amortization methods depends on the nature of the asset, regulatory requirements, and financial reporting objectives. Each process impacts the financial statements by influencing the allocation of expenses and the carrying value of assets or intangibles over time.

The following are the four depreciation methods that align with accounting standards:

1. Straight-Line Depreciation: This method allocates an equal depreciation expense yearly over an asset’s useful life.
2. Declining Balance Depreciation applies a fixed percentage to the asset’s declining book value. This method accelerates depreciation. 
3. Units-of-Production Depreciation: This method applies depreciation based on usage or production output rather than time. It is suitable for assets like machinery. 
4. Sum-of-the-years’ Depreciation: A declining fraction is applied to the asset’s depreciable cost based on the sum of the years’ digits 

For preparing financial statements, you could choose from the following amortization methods:

1. Straight-Line Amortization: This method allocates equal amounts of amortization expense over the useful life of the intangible assets, like patents or copyrights. 
2. Declining Balance Amortization: This method accelerates amortization by allocating higher amounts in the early years. 
3. Annuity Amortization: It is used for loans or bonds. It amortizes a fixed annual amount, with interest payments decreasing over time as the principal is paid. 
4. Effective Interest Rate Amortization: This method applies a constant periodic interest to amortize a financial liability or asset. 

3. Inventory valuation policies

Inventory valuation policies help determine the value of your inventory on the financial statements. The overall objective of inventory valuation is to present the company’s gross profitability accurately. Valuation of inventories helps calculate the cost of goods sold and the cost of the unsold inventory and thus affects the profitability of your business. 

Let’s look at the inventory valuation methods you can select from.

• First-In, First-Out (FIFO)

The FIFO method is based on the concept that the first inventory purchased is the first to be sold. The remaining assets in the stock are matched to the most recently purchased or produced assets. It is a simple and easy method but may not be accurate when prices are rapidly spiked.

• Last-In, First-Out (LIFO)

This method assumes that the more recent inventory is sold first and the older inventory remains in stock. Unless businesses expect the inventory cost to increase over time, this method could result in significant loss as the older inventories are rarely sold and gradually lose their value. 

• Weighted average methods

In this method, the weighted average determines the amount that goes into the cost of goods sold and inventory. It is commonly used to determine a price for units that are indistinguishable from one another, and individual costs cannot be tracked.

Impact on cost of goods sold

Inventory valuation helps calculate the cost of goods sold and the cost of the unsold inventory and thus affects the profitability of your business. 

To calculate the gross profit, a company must subtract the cost of goods sold (COGS) from net sales. 

The method chosen by a company to evaluate its inventory affects its cost of goods sold (COGS) and directly impacts its gross profit.

4. Asset valuation policies

This type of a policy determines the value of all your tangible and intangible assets. Asset valuation policies impact the company’s balance sheet and influence key financial ratios. Standard asset valuation methods are the historical cost method and fair value method. Let’s compare the two methods. 

Historical cost vs. fair value

Aspect	Historical Cost Method	Fair Value method
Basis	Assets are recorded at their historical cost for which the asset was bought	Assets are reported at their current market value
Adjustments	Generally, no subsequent adjustments are made to the value	Assets are frequently revalued to their fair market value
Approach	It is a conservative approach as the value of assets is lower than current market value	It reflects the actual value of the assets
Simplicity	It is simpler to apply. No revaluation is necessary	It can be more complex, especially while evaluating unique assets
Income statement impact: The	Income statement is affected only when the asset is sold, resulting in stable reported profits.	Fluctuations in reported income as asset value changes with market conditions

Impairment assessment

An impaired asset is an asset that has a market value less than the value listed on the company’s balance sheet. Assets are tested for impairment regularly to ensure the company’s total asset value is not overstated on the balance sheet. 

Impairment assessment is a process that evaluates whether the carrying value of assets exceeds their recoverable amount. If the recoverable amount is lower than the carrying amount, an impairment loss is recognized on the company’s income statement in the same accounting period. 

Impairment assessments help maintain accurate financial reporting, manage financial risks, and ensure transparency and compliance. 

Asset accounts likely to become impaired are the company’s accounts receivable, goodwill, and fixed assets.

Read More: 10 Best Asset Management Software Systems

How are accounting policies used?

Many company financial statement items are calculated using specific methods and formulae. Different acceptable practices are available for the same item. The company’s accounting policy defines the methods and formulae to be used by the company. 

Accounting policy choices may be within the allowances approved by the accounting standards, but they can significantly change the numbers on the financial statements. For example, different ways to calculate depreciation and inventory costs will give you very different values. 

Since the choices are flexible, a company can choose policies to its advantage. Therefore, it is a legal way of changing the direction or implication of a financial statement. For example, a financial report that looks very impressive may be the result of an aggressive accounting policy. 

A company’s accounting policies must be examined thoroughly before reading the financial statements to understand the entire story.

Developing accounting policies

Establishing accounting policies for your organization needs an investment of your time and effort. There is no “one size fits all.” Accounting policies must be tailored to your business’s nature, economic environment, and specific accounting needs. 

1. Factors influencing policy decisions

• Relevance: The accounting policy should be relevant to your business operations. Relevant information possesses predictive value and confirmatory value. 
• Reliability: The policy selected should faithfully represent the transactions and be neutral. It should be prepared prudently under conditions of uncertainty.
• Materiality: It should be appropriate to the size of your business and the impact of the accounting treatment on the financial statements. 

2. Setting consistency and comparability

Useful financial information should be comparable to financial information relating to a different period of the company and  other companies’ financial information. Comparability can be achieved by setting consistency in policies. 

3. Documenting accounting policies

The accounting policies can be found in the accounting manual. It is an internal handbook establishing the company’s pertinent accounting rules, policies, and procedures for its accounting staff.

It is used as a reference tool by the employees and as a training guide. 

The benefits of documenting accounting policies are multi-fold:

• Enables accounting staff and management to work seamlessly by using the manual as a reference tool
• Ensures consistent application of accounting policies 
• Internal controls minimize financial fraud
• Serves as a key tool in training new employees
• Ensures compliance with audit and regulatory requirements

4. The role of professional judgment

Appropriate professional judgment is crucial in preparing reliable and transparent financial statements. It should be well-reasoned, well-documented, and uphold ethical standards.

The role of such  judgments is to emphasize the constructive effort of your company to provide a clear and adequate reflection of its financial reality. Then, they can be defended in both the internal reviews and external inspections. 

Since such decisions are not essentially right or wrong, it may be challenging. Poor professional judgments can be linked to improper application of accounting policies, exposing you to unfavorable financial consequences.

Ultimately,  the quality and integrity of the decisions result in projecting correct numbers, making your company valuable and trustworthy in the business world. 

Also, Read: Financial Accounting: Definition, Types, Functions & Examples

Implementing accounting policies

You have now crafted accounting policies to suit your business. The next step is to put them into practice consistently and effectively. Implementation involves integrating the guidelines into the day-to-day financial operations of the company.

Let’s take a look at the necessary steps to make this happen.

1. Training and communication

After creating and documenting the accounting policies for your company, the next crucial step is to ensure your accounting staff understands them and follows these guidelines. 

It is best to develop a communication and training plan to introduce the accounting manual to the relevant stakeholders, including the accounting staff, managers, and executives. Utilizing real-life scenarios and case studies will give more clarity and demonstrate the practical application of the guidelines. As accounting policies may vary between companies, training sessions will particularly help recruits. 

Investing in training workshops will help facilitate consistency, reduce errors, and boost compliance. 

2. Monitoring and enforcement

Internal procedures to monitor the implementation of accounting policies are critical. The accounting department monitors the enforcement of these internal controls and procedures.

Internal controls safeguard the reliability of accounting policies within your company. Other benefits are:

• Maintains accurate financial reporting
• Eliminates fraud
• Ensures compliance with regulations
• Increases accountability
• Outlines clear policy guidelines for all staff

Setting up a feedback system for employees and stakeholders to ensure continuous improvement is a good idea.

3. Addressing changes in policies

Your accounting manual will also have to evolve as the business environment evolves. The manual must be regularly reviewed and policies updated to reflect changes in regulations, industry practices, and your business needs. 

Policy changes are permitted only if 

• it is required by the standards 
• the management can prove that it will make the financial statements more reliable and relevant. 

These changes to accounting policies need to be applied retrospectively. The purpose is to maintain comparability of current financial results with previous periods.  The reason, nature, and effects of the change must be disclosed.

4. Ensuring compliance with regulatory requirements

Accounting policies are flexible and vary from company to company. Still, all these policies must conform to one of the two standards – Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). These are standards created for ethical and accurate financial reporting. Failure to comply can result in legal and financial consequences, including fines and reputational damage. 

Ensuring compliance with these regulatory requirements is beneficial in other ways.

• Consistency allows external parties to perform quick and accurate cross-company comparisons
• Transparency and continuity enable investors and stakeholders to make sound, evidence-based decisions
• Allow companies to evaluate strategic business options 
• Plays a vital role in your company’s external activities like raising capital, public trading, preparing for transactions such as mergers or acquisitions, or qualifying for recent stimulus loans, grants, and loan waiver.

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Examples of common accounting policies

Here are some accounting policies examples that play a significant role.

1. Revenue recognition

The revenue recognition accounting policy defines rules to be applied while recognizing revenue in the financial statements. 

Depending on the method used, revenue can be recognized at different times. For example, if you use the accrual basis, sales made on credit are also recognized as revenue. In contrast, if you use a cash basis, your company will only record revenue when cash is received.

This kind of a policy will impact your company’s income statement and play an essential part in financial reporting.

2. Depreciation

The methods used to calculate depreciation, like the straight-line, declining, or unit production methods, can impact your financial statements and profitability. 

The depreciation accounting policy needs to spell out the depreciation method to be applied, the rate of depreciation, the disposal process, and the capitalization of expenses. 

The accounting policy of depreciation ensures that the financial reporting accurately reflects the wear and tear of assets. It contributes to transparency and helps manage your assets efficiently.

3. Inventory valuation 

Inventory is a vital asset of any manufacturing or trading organization, so its valuation significantly affects your business. 

Such valuation determines your company’s inventory’s monetary value at any specific time. To value inventory, you can choose from various methods, like FIFO, LIFO, and average cost method. The accounting policy for inventory valuation is then developed based on this choice.

The choice of the valuation method can impact your financial statements, profitability, and tax obligations. Also, your valuation method should align with the accounting standards you adopt. For example, IFRS does not approve the use of the LIFO method. 

Read More: 8 Best Inventory Management Software

4. Goodwill impairment

Goodwill impairment is an earnings charge that a company records on its income statements after realizing that the asset attached to the goodwill can no longer produce the expected financial results at the purchase time. 

Accounting standards require companies to review their goodwill for impairment at least annually at a reporting unit level. 

This policy of the company defines this reporting unit. Reporting units typically represent distinct business lines, geographic units, or subsidiaries. The definition of the reporting unit is crucial and affects the financial statements accordingly. 

5. Lease accounting

The lease accounting policy establishes accounting treatment for lease agreements. 

Leases can be of three types: 

• Direct financing
• Sales-type
• Operating leases. 

The policy should define the lease classification because it determines the company’s accounting and reporting requirements. 

Generally accepted accounting principles require recognizing the effect of a leasing contract on the balance sheet. At the end of the year, financial reporting analyzes all lease costs and commitments and supplies this information to external auditors. 

Read About: What is Accrual Accounting: Meaning, Principles and Example

Impact of accounting policies on financial statements

Accounting policies profoundly affect the appearance and interpretation of financial statements. For example, different approaches for revenue recognition, expense allocation, and asset valuation will lead to variations in reported revenues, expenses, assets, and liabilities. These parameters are the key ingredients in preparing the financial statements. 

Let’s take a look at how policies impact each of the financial statements.

1. Balance sheet

The balance sheet is one of the five financial statements a company distributes. It reports your company’s assets, liabilities, and stockholder’s equity as of the end of an accounting period. 

Several accounting policies influence the amounts reported on the balance sheet. 

For example, a revenue recognition policy will affect the timing of recognizing the revenue recorded as an asset. Procedures of inventory valuation, depreciation, lease accounting, or valuation of investments will all alter the recognition and measurement of assets, liability, and equity. 

2. Income statement

The income statement reports the revenue generated by the company during the period and the expense it incurred in earning that revenue. Accounting policies like revenue recognition, expense recognition, inventory costing methods, amortization of intangible assets, and employee benefits will all impact the income statement.

3. Cash flow statement

The cash flow statement gives the cash inflows and outflows of your company’s operating, investing, and financing activities. Some accounting policies and practices indirectly impact the cash flow statement. 

For example, 

1. The revenue recognition policy will change the timing of revenue recognition, which may affect cash flow from operating activities. 
2. The expense recognition policy can affect the net income calculation, consequently impacting the operating cash flows. 
3. The investment valuation policy impacts the investing activities when investments are bought or sold. It will affect the cash flow statement. 

4. Disclosures in footnotes

Accounting policies play a direct role in the content and presentation of disclosures in financial statements. The choice of the company’s policies, their application, and any changes made to the policies are included under the disclosures in the footnotes.

Also, accounting policies significantly affect the view presented in the financial statements. Investors and stakeholders can analyze and interpret the company’s economic reality when considering the numbers in tandem with the disclosed accounting policies. 

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Difference between accounting principles and accounting policies

Broadly, accounting principles are the accounting profession’s fundamental principles and standards. In contrast, accounting policies are company-specific practices implementing those principles in preparing financial statements. 

Let’s chalk out the differences point-wise.

Aspect	Accounting Principles	Accounting Policies
Purpose	Provides a framework for standardized financial reporting	Provides details of how financial transactions are measured, recorded, and disclosed
Relevance	Applies to the entire accounting profession	Company-specific, selected to align with applicable accounting principles and meet business needs
Level of detail	Broad and macro level guidelines	Detailed, particular guidelines customized to the company’s financial practices
Selection authority	Established by governing accounting bodies like FASB, IASB	Set up by the company’s management in line with the applicable principles like GAAP, IFRS
Compliance	Mandatory for all business entities	May vary across companies but need to align with accounting principles
Disclosure	Generally not disclosed in the financial statements	Mandatory to be disclosed in the financial statements
Example	Accrual basis of accounting, Historical cost principle	Depreciation method (straight line or declining balance), Inventory valuation method (FIFO or LIFO)

Read More: Difference Between Cost Accounting and Financial Accounting

Importance of transparent and consistent accounting policies

Transparent and consistent accounting policies translate into accurate financial reporting. It guarantees that the data presented is exact, uniform, and dependable. 

Adhering to such policies results in financial statements that precisely showcase your company’s operations and performance. In business, clear and comprehensive financial statements can be very beneficial.

1. Building investor confidence

Investors rely heavily on financial statements to decide whether or not to invest in your company. Transparent and responsible financial reporting will help investors effectively evaluate and decide. It will boost confidence amongst investors. 

2. Facilitating comparability

Consistency in accounting principles facilitates meaningful comparisons between companies, industries, and reporting periods. Investors and analysts can assess financial performance by comparing the financial data without complications of varying accounting methods. 

3. Mitigating financial risks

Good accounting policies ensure compliance with accounting standards and regulatory requirements. By adhering to recognized standards, your company can reduce the risk of regulatory penalties, fines, or legal actions resulting from non-compliance.

4. Strengthening corporate governance

Transparent financial reporting enhances corporate governance by promoting accountability and preventing financial irregularities and unethical practices. Also, it enables the management to assess the company’s financial performance better and make strategic decisions for the future. 

Quick Read: What Is Cost Accounting? Types, Objectives, Methods & Functions

Challenges and controversies in accounting policies

Companies can choose policies for their accounting practices. This flexibility produces opportunities for financial statement manipulation, posing challenges to investors. Controversies also arise when companies implement aggressive policies and push the boundaries of accepted standards.

Here are a few controversial strategies companies adopt to make themselves more attractive to investors.

1. Earnings management

Earnings management is a strategy a management uses to manipulate the company’s earnings deliberately. 

For example, you may move earnings from one reporting period to another to paint a better picture or manipulate the balance sheet to hide liabilities and inflate profits.

Such a manipulation makes the financial reports look better than it is. Intentional misrepresentation attracts fines and other punishments from regulatory boards.

2. Subjectivity vs. objectivity

Subjectivity refers to financial decisions that rely on personal judgment and interpretation. On the other hand, objectivity implies that financial decisions are based on verifiable facts and evidence.

Accounting is a mixture of subjective and objective elements. 

For example, subjective elements can be estimating the life of an asset or determining the fair value of specific investments. Objective elements can be cash transactions or market prices for traded securities.

Companies must balance these two contrasting concepts while preparing financial statements by

• Implementing policies for making objective determinations  
• Providing transparent disclosure when subjectivity is involved

If the balance is tilted more towards subjectivity, the uncertainty and variability in the financial statements will be higher. It can potentially be used to manage earnings or manipulate financial results. Objectivity in accounting ensures the reliability and credibility of financial information published.

3. Conflicts with auditors and regulators

Conflicts with auditors and regulators can impact the accuracy and reliability of financial statements. Conflict resolution is crucial to maintain the integrity of financial reporting. 

Some potential conflict scenarios that can lead to adverse opinions and compromise the accuracy of the financial statements:

• Disagreements on accounting policies: Auditors and management may not see eye to eye on the selection or application of accounting policies
• Unresolved audit issues: When issues identified by the auditors during the audit process are unresolved by management
• Scope limitations: If management restricts the scope of the audit by limiting access to information
• Pressure to override controls: If auditors face pressure from management to ignore internal rules or audit procedures

4. Emerging issues in accounting policies

The evolving landscape of financial reporting has led to emerging issues that are shaping many accounting policies. 

Some key emerging issues that accounting policies must find ways to integrate into financial reporting are

• Digital and cryptocurrency assets
• Artificial intelligence and automation
• Cybersecurity and data privacy
• Environmental, Social, and Governance (ESG) reporting
• Inclusion of non-financial metrics like customer satisfaction, brand reputation
• Complex supply chain finance

Must Read: 9 Best Accounting Software for Small Business

Conclusion

Accounting policies provide a framework for the business to operate, record its daily transactions, measure its assets and liabilities, and prepare its financial statement. They are the basis on which financial statements are prepared across the world. Following it helps maintain consistency and increases investors’ trust in the business.

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