What Are Accounting Policies?
Accounting policies are the specific principles and procedures carried out by a company's management team that are utilized to prepare its financial statements. These incorporate any accounting methods, measurement systems, and procedures for introducing exposures. Accounting policies vary from accounting principles in that the principles are the accounting rules and the policies are a company's approach with complying to those rules.
How Accounting Policies Are Used
Accounting policies are a set of standards that oversee how a company prepares its financial statements. These policies are utilized to deal specifically with convoluted accounting practices, for example, depreciation methods, recognition of goodwill, readiness of research and development (R&D) costs, inventory valuation, and the consolidation of financial accounts. These policies might vary from one company to another, yet all accounting policies are required to adjust to generally accepted accounting principles (GAAP) as well as international financial reporting standards (IFRS).
Accounting principles can be considered a structure in which a company is expected to operate. Nonetheless, the structure is to some degree flexible, and a company's management team can pick specific accounting policies that are profitable to the financial reporting of the company. Since accounting principles are tolerant on occasion, the specific policies of a company are vital.
Investigating a company's accounting policies can signal whether management is conservative or aggressive while reporting earnings. This ought to be considered by investors while auditing earnings reports to evaluate the quality of earnings. Likewise, outside auditors who are recruited to survey a company's financial statements ought to audit the company's policies to guarantee they adjust to GAAP.
Company management can choose accounting policies that are profitable to their own financial reporting, for example, choosing a specific inventory valuation method.
Illustration of an Accounting Policy
Accounting policies can be utilized to control earnings legally. For instance, companies are permitted to value inventory utilizing 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 delivered or acquired in the accounting period is utilized to decide the cost of goods sold (COGS).
Under the FIFO inventory cost method, when a company sells a product, the cost of the inventory created or acquired first is viewed as sold. Under the LIFO method, when a product is sold, the cost of the inventory created last is viewed as sold. In periods of rising inventory prices, a company can utilize these accounting policies to increase or diminish its earnings.
For instance, a company in the manufacturing industry purchases inventory at $10 per unit for the main half of the month and $12 per unit for the final part of the month. The company winds up purchasing a total of 10 units at $10 and 10 units at $12 and sells a total of 15 units all month long.
On the off chance that the company utilizes FIFO, its cost of goods sold is: (10 x $10) + (5 x $12) = $160. In the event that it utilizes average cost, its cost of goods sold is: (15 x $11) = $165. Assuming that it utilizes LIFO, its cost of goods sold is: (10 x $12) + (5 x $10) = $170. It is hence profitable to involve the FIFO method in periods of rising prices to limit the cost of goods sold and increase earnings.
- Accounting policies are procedures that a company uses to prepare financial statements. Dissimilar to accounting principles, which are rules, accounting policies are the standards for adhering to those guidelines.
- A company's decision in accounting policies will demonstrate whether management is aggressive or conservative in reporting its earnings.
- Accounting policies might be utilized to legally control earnings.
- Accounting policies actually need to stick to generally accepted accounting principles (GAAP).