Updated July 20, 2023
Definition of Accounting Policies
Accounting policies refer to the set of principles and procedures laid down by the management of an entity that is to be applied by the entity to prepare and present its financial statements. The policies can be for measurement of assets and liability, accounting methods to be followed for any accounting item, disclosures, presentation, etc.
Explanation
This chosen by a company’s management can be explained as a framework in which the company is expected to record its day-to-day transactions, value its assets and liabilities, and report its financial results. The company can follow its own sets of specific policies. But they should be in compliance with the GAAP or IFRS depending upon the country of operation.
A company’s choice of accounting policies tells a great deal about its reported earnings; it hints whether management is aggressive or conservative in its approach of reporting the earning. This can be very helpful for investors while they are reviewing the company’s financial position. But the company should be consistent in its accounting policies and should not change the policies they are following since the onset until it is required by an act, standard or the change is such that it is necessary to give a fair view of the company’s financial affairs. Further, if the company changes its accounting policies, such changes shall be properly disclosed in the financial statements along with proper justification.
Examples of Accounting Policies
A few of the examples of different areas for which accounting policies are applied by the companies are as follows:
- Valuation of Inventory: The Company chooses a specific accounting policy for the method of valuation of inventory. For example, a company may adopt the FIFO method, LIFO method, or average cost method. However, IFRS doesn’t allow the companies to use the LIFO method and the companies which are covered by these standards shall not deploy this method.
- Depreciation: For depreciation accounting company chooses different methods of calculating depreciation like straight-line method, double declining method, sum of year’s digits, unit of production, etc. Accounting policy for depreciation would include expenses that can be capitalized, depreciation rate, disposal process, and so on.
- Revenue and Expenses: Accounting policy for revenue recognition and measurement could include that revenue can only be recognized once goods or services are received by the customers and therefore, a proof of receipt signed by the customer would be required as evidence of revenue recognition in accounting books or financial statement.
Similarly, in case of expenses, the company may choose to recognize expenses when they are incurred i.e. accrual basis of accounting, instead of when they are paid i.e. cash basis of accounting.
Selection of Accounting Policies
- While selecting an accounting policy company must keep in mind that if any particular accounting standard applies to any transaction or event, then accounting policy should be applied as per the standard. But if no particular standard applies then the company can develop policy on the basis of own judgment and experience of facts and circumstances.
- During the process of developing a policy, a company should check for other standards dealing with similar kinds of events and check for the concepts regarding the treatment and meaning of assets, liabilities, income, and expenses in the accounting framework. Apart from this, businesses may also give importance prudence concept which states that gains are not anticipated and are recognized only when they are realized, while provision is created for all anticipated liabilities and losses.
- But it should always be kept in mind that selected accounting policy should give a precise and accurate presentation of the company’s financial affairs.
Nature of Accounting Policies
The nature of accounting policy is not objective but subjective. There is no exhaustive list of all the accounting policies available which can be applied in every circumstance. Companies choose alternative methods of policies as per their individual circumstance which is acceptable; this is majorly driven by a lot of research and judgment by the management of the company.
The nature of policies shall be such that they give a true and fair view of the financial affairs of the business. Also, this shall be applied with consistency from one year to another so that uniformity is maintained.
Uses and Importance of Accounting Policies
Below points justify the importance :
- This serves as a guide to accountants and management of the company while preparing the financial statements.
- They help in providing a ready reference for the similar set of circumstances that the company may come across.
- They help in maintaining consistency in the presentation of the financial statement which leads to easy comparison from the previous year or with other organizations.
- They help in maintaining internal control by following the set procedure for similar kinds of transactions.
- They help investors in the analysis of financial statements while they are deciding if they should invest in certain businesses or not.
Conclusion
Accounting policies provide a framework for the business in which it is expected to operate, record its day to day transaction, measure its assets and liabilities, and prepare its financial statement. They are an integral part or basis on which financial statements are prepared across the world. This should be followed religiously as it helps in maintaining consistency and also increase investors’ and shareholder’s trust in the business.
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