What are Accounting Policies?

As the top management sets the benchmarks for maintaining the quality of the products or services in a company, accounting policy is also set as benchmarks to represent a sound and accurate picture of accounting practices within a company.

Accounting policy may vary from company to company. Still, whatever a company does regarding accounting policy, it should be per the generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS).

Significance of accounting policies

They are significant for the following reasons –

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Accounting Policies Examples

All financial statements are prepared by following specific policies. Here are a couple of practical examples which will help us understand how they are monitored –

Example #1 – Revenue Recognition

Companies follow generally accepted accounting principlesAccounting PrinciplesAccounting principles are the set guidelines and rules issued by accounting standards like GAAP and IFRS for the companies to follow while recording and presenting the financial information in the books of accounts.read more to recognize revenues. Recognizing revenue for the company is important because it positively or negatively impacts the investors if a company recognizes its revenue when it doesn’t make any sales. As per the revenue recognition principle, a company can’t verify its revenue until it is earned. That doesn’t mean all revenue would be in cash. In the case of credit salesCredit SalesCredit Sales is a transaction type in which the customers/buyers are allowed to pay up for the bought item later on instead of paying at the exact time of purchase. It gives them the required time to collect money & make the payment. read more, earning is also real.

For example, Company T makes credit sales and recognizes it as revenue; two things are essential. First how first Company T can collect the cash for the credit sales. And secondly, when the revenue is recognized – at the time of making the credit sales or receiving cash. If a company recognizes revenue by recording credit sales and doesn’t receive any cash by that point, the company would be called rich in revenue but poor in cash. Accounting policy significantly affects how revenue is being recognized in a company.

As we see from the example below, Ford recognizes its Automotive segment revenue when all the risks and rewards of ownership are transferred to customers (dealers and distributors).

source: Ford SEC Filings

Example #2 – R&D Expenses

R&D Expenses – which are capitalized and which are called expenses? This is a significant consideration in financial accountingFinancial AccountingFinancial accounting refers to bookkeeping, i.e., identifying, classifying, summarizing and recording all the financial transactions in the Income Statement, Balance Sheet and Cash Flow Statement. It even includes the analysis of these financial statements.read more, and a company needs to follow the accounting policy to recognize the expenses or the capitalization. But how is it done? R&D expenses certainly have future benefits. That’s why R&D expenses have been treated as assets rather than expenses. But when a company is expensing R&D, it doesn’t know any specific future benefits. That’s why it can’t be capitalized in most cases. Sometimes when R&D expenses have specific future benefits, they can be capitalized. As per GAAP, one should recognize R&D expenses when they’re incurred.

We note from below Apple’s total R&D expense was $11.6 billion and $10.0 billion in 2017 and 2016, respectively.

source: Apple SEC Filings

Also, have a look at Capitalization vs ExpensingCapitalization Vs ExpensingCapitalization recognizes the cost incurred as an expenditure that is capital in nature or as a business asset, whereas expensing refers to booking cost as an expense in the business’s income statement, deducted from the total revenue while calculating the profits.read more.

Accounting Policies – Conservative vs. Aggressive

Typically firms operate within the periphery of two extremes regarding accounting policy.

Either a firm follows an aggressive approach or a conservative approach.

No matter what approach a company follows, it needs to reflect the same in its accounting and how the accounting policies are followed in preparing the financial statements.

The same will also affect profits. An aggressive approach may end up generating more/fewer book profitBook ProfitBook Profit is the profit amount that a business earns from its operations & activities but has not been realized yet. It is not tracked by analysts or stakeholders & its calculation is relevant only to evaluate a Company’s tax liability. read more. And a conservative approach may do the same. The company should stick to one specific method so that coherence is maintained.

Suppose the company changes its approach from aggressive to conservative or conservative to aggressive. In that case, it should be mentioned why it has been changing its approach to protecting the interests of the investors.

According to International Accounting Standards 8, accounting policies are conventions, rules, procedures, principles, bases, and practices. That means the whole framework of accounting standards in preparing and presenting the company’s financial statements can be called accounting policies.

The accounting approach to using the accounting policy shouldn’t be based on a single transaction or event, or condition. Instead, the accounting policy should be used by keeping the big picture in mind and thinking about the preparation of financial statements and how these financial statements would be represented to the investors.

Accounting Policies Video

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