Accounting policies are the foundation of each and every business and financial organization, and they set the standards for the preparation and presentation of financial statements. Such policies are important not only in ensuring the comparability of financial reporting but also in creating a framework in which stakeholders can transparently evaluate a company’s financial condition. Today, we will look at accounting policies in detail, their types with examples and their impact on financial accounting.

What are Accounting Policies

Accounting policies are the rules and methods a company employs to organize and manage its financial accounting practices. Such policies help to align financial reports to the relevant and widely accepted accounting standards.

Accounting principles provide the general framework, whereas accounting policies specify how the company will implement that framework in its daily operations. For example, the policies determine how the company records financial transactions related to procurement, revenue and inventory.

The Purpose of Accounting Policies

One of the vital functions of accounting policies is to ensure standardization of financial statements across periods and companies. Let’s explore the significance 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

Depending on the financial strategies and the industry they are in, companies may decide on using different accounting policies that work well for their operations. Below are some of the areas where companies tend to assign specific accounting policies:

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.

Read more: Balance sheet formats

Types of Accounting Policies

Accounting policies and their implementation can differ across companies, industries, and locations. Let’s look at some of the commonly used and accepted accounting policies.

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

Let’s explore each of these types in detail and understand them better with accounting policy examples.

Revenue Recognition

Revenue recognition addresses the timing of recording a company’s revenue. This record timing can significantly affect a company’s financial health. The two categories to consider under revenue recognition are:

• 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.

Example: An IT services company has decided to use an accrual basis of revenue recognition. Thus, it records revenue when a client confirms and signs the contract, even if the client makes the payment later. 

Significance: Revenue recognition policies influence income statements and balance sheets. Deferring revenue may result in understated earnings, while prematurely recognizing revenue may cause overstated earnings and thereby misrepresent a firm’s financial status.

Expense Recognition

The expense recognition policy of a company describes how and when its expenses will be recorded. The matching principle is most commonly used. It dictates that all expenses of a company must be matched with the related revenues they helped create.

Example: A company that incurs cost of goods sold (COGS) must record expenses in the same period as the product is sold and the company earns revenue from the sale.

Significance: Recognition of expenses in the correct time period is important in ensuring that the income statement reflects the true picture of a firm’s profitability. Errors in policy implementation can negatively affect the net income value.

Inventory Valuation

This policy determines how companies value their inventory of unsold tangible products. Below are the three policy types used for valuing inventory.

• 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. 

Example: A retail business that values its inventory using FIFO method assumes the inventory it caught first will be sold first. Thus, their financial statements may reflect lower COGS and higher reported earnings, during periods of price rises.

Significance: Valuation policies have a direct impact on COGS, net income and inventory value on the financial statements. The selection of FIFO, LIFO, or average cost may alter financial results, and the choice of a method may be driven by tax reasons.

Read more: Financial Accounting

Depreciation

Depreciation is the process of spreading the cost of a tangible fixed asset over its useful life. Here are the common depreciation policies used by companies.

• 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.

Example: A manufacturing company that uses straight-line depreciation will charge the same depreciation expense every year for the useful life of the equipment.

Significance: The depreciation method used influences a company’s net income and the amount of the assets on its balance sheet. Accelerated methods like double-declining can lead to lower net come in the initial years but can offer tax benefits.

Asset Valuation

The policy determines how the company records its assets on the balance sheet. These could be tangible and intangible assets such as machinery and goodwill. The two common asset valuation methods used are:

• 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.

Example: If a company employs the historical cost method, it will record the purchase of a piece of real estate at the price it paid for it, even though its market price has risen over the years.

Significance: The policy determines how the company prepares its financial statements and makes changes. For example, a company using the fair value method will be required to frequently change its financial statements to reflect market value.

Goodwill Impairment

When a company acquires an asset by paying more than its book value, the transaction is termed as goodwill. If the asset value declines after the transaction, goodwill impairment occurs and the same is recorded in the company’s financial statements.

Companies must assess the goodwill impairment value annually. If the impairment amount is higher than the book value, the difference is recognized as a loss.

Example: If a company acquires an asset for ₹100,000 but it later assesses the book value of the asset to be ₹80,000, ₹20,000 would be recorded as goodwill impairment.

Significance: If a goodwill impairment occurs then it will be recorded as a loss on the income statement and a reduced goodwill be recorded on the balance sheet.

Lease Accounting

The policy determines how a company manages its lease agreements. The two common lease types are as follows:

• 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.

Example: A firm leasing an office space may treat the transaction as an operating lease, meaning the rental payments will be recorded as operating expenses while the asset is kept off the balance sheet.

Significance: Lease accounting policies impact the assets, liabilities and expenditure of a firm. For example, financial leases can increase the firm’s leverage whereas operating leases keep liabilities off financial statements.

Read more: Expense management software

Impact of Accounting Policies on Financial Statements

Accounting policies impact the financial statements of companies in the following ways:

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.

Read more: Cashflow analytics

Conclusion

Accounting policies are a crucial aspect of how organizations report their finances. They provide the overall framework for recording, measuring and presenting financial transactions, which in turn affects the perception investors, regulators, employees and other key stakeholders have of a company. They help to shape how revenues are recognized, inventories are valued, and depreciation is recorded, ultimately leading to the creation of income and balance statements.

Accounting policies provide benefits like consistency, comparability, and transparency. They also aid stakeholders make informed financial decisions. Accounting policies when applied correctly can provide a foundation for long-term financial growth and stability.

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?

Various factors such as regulatory changes, economic developments or industry practices could require companies to change their accounting policies. For instance, a change in tax law could cause companies to change the way that they depreciate assets, or the transition from national accounting standards to IFRS could require policy overhauls.