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Accounting policy

What Is Accounting Policy?

An accounting policy refers to the specific principles, bases, conventions, rules, and practices applied by a company in preparing and presenting its financial statements. These policies are critical components within the broader field of financial reporting as they dictate how transactions and events are recognized, measured, presented, and disclosed. The selection of appropriate accounting policies is vital for accurately reflecting a company's financial position, profitability, and cash flow.

Accounting policies enable consistency in a company's financial records over time and comparability with other entities. Without clear guidelines, companies might record similar transactions differently, making it challenging for investors and other stakeholders to assess performance.

History and Origin

The development of structured accounting policies evolved alongside the growth of complex business transactions and the need for greater transparency in financial markets. Historically, accounting practices varied significantly, leading to inconsistencies and difficulties in comparing financial performance across companies. The establishment of formal accounting policies gained significant momentum in the 20th century with the rise of regulatory bodies and professional accounting organizations.

In the United States, the Financial Accounting Standards Board (FASB) was established in 1973 as the independent, private-sector organization responsible for creating and improving Generally Accepted Accounting Principles (GAAP).6 This marked a turning point, providing a unified framework for U.S. companies. Internationally, the IFRS Foundation was created in 2001, developing International Financial Reporting Standards (IFRS), which are now adopted in over 140 jurisdictions worldwide, further standardizing accounting policy principles.5

A notable historical example of the evolution of accounting policy is the issuance of Staff Accounting Bulletin (SAB) No. 101 by the U.S. Securities and Exchange Commission (SEC) in December 1999. This bulletin provided critical interpretive guidance on revenue recognition, addressing concerns that companies were manipulating reported income through aggressive revenue practices.4 SAB 101 clarified the criteria for revenue recognition, significantly impacting how many companies reported their top-line figures.

Key Takeaways

  • Accounting policies are the specific rules and practices a company follows for its financial reporting.
  • They ensure consistency, comparability, and transparency in financial statements.
  • The choice of accounting policy can significantly impact reported assets, liabilities, equity, expenses, and revenue.
  • Major frameworks like GAAP and IFRS govern accounting policies globally.
  • Companies must disclose their significant accounting policies in their financial statements.

Interpreting the Accounting Policy

Interpreting a company's accounting policy requires careful review of the disclosures made in the footnotes to the financial statements. These disclosures explain the specific methods a company uses for recognizing revenue, valuing inventory, depreciating property, plant, and equipment, accounting for leases, and handling other complex transactions. Understanding these policies is crucial because different acceptable policies can lead to varying reported financial results, even for economically similar transactions.

For instance, a company using the FIFO (First-In, First-Out) inventory method will report a different cost of goods sold and ending inventory balance than a company using the LIFO (Last-In, First-Out) method, especially in periods of rising prices. Financial analysts and investors must understand these differences to make accurate comparisons and informed decisions. The choices in accounting policy reflect management's judgments and can offer insights into the company's financial philosophy and strategic goals.

Hypothetical Example

Consider two hypothetical construction companies, Company A and Company B, both undertaking long-term projects.

Company A adopts the "percentage-of-completion" accounting policy for revenue recognition on its long-term contracts. Under this policy, revenue and profits are recognized as the work progresses, based on the costs incurred relative to the total estimated costs. If a project is estimated to cost $10 million and $3 million has been incurred, Company A would recognize 30% of the total estimated revenue for the project.

Company B, conversely, adopts the "completed-contract" accounting policy. Under this policy, revenue and profits are only recognized once the entire construction project is finished and delivered.

For a project spanning three years:

  • Year 1: Both companies begin a $20 million contract with an estimated profit of $4 million. Company A incurs $5 million in costs, recognizing $4 million in revenue (20% of $20 million) and $0.8 million in profit (20% of $4 million). Company B incurs $5 million in costs but recognizes no revenue or profit.
  • Year 2: Company A incurs another $8 million in costs (total $13 million), bringing the project to 65% completion. It recognizes an additional $9 million in revenue ($13 million / $20 million total cost * $20 million total revenue - $4 million already recognized) and $1.8 million in profit. Company B still recognizes no revenue or profit.
  • Year 3: The project is completed. Company A recognizes the remaining revenue and profit. Company B finally recognizes the full $20 million in revenue and $4 million in profit.

This example highlights how different accounting policies, both acceptable under certain conditions, can significantly alter the timing of reported revenue and profit, influencing a company's reported net income in any given period.

Practical Applications

Accounting policies are fundamental to how businesses operate and how external parties understand their financial health. They are routinely applied in several key areas:

  • Corporate Financial Reporting: Every public and private company uses a specific set of accounting policies to prepare its primary financial statements, including the income statement, balance sheet, and cash flow statement. These policies ensure that financial information is consistent and comparable over time.
  • Investment Analysis: Investors and financial analysts scrutinize a company's accounting policies to understand the true underlying performance and compare it against competitors. Different policies can lead to vastly different reported figures, making policy analysis a critical part of due diligence.
  • Regulatory Compliance: Regulatory bodies, such as the SEC in the U.S., mandate that companies adhere to specific accounting policies and adequately disclose them. For example, the SEC's Staff Accounting Bulletin 101 significantly impacted how businesses in various sectors recognized revenue, leading to adjustments in their accounting policies.3
  • Auditing: Independent auditors examine a company's adherence to its stated accounting policies and the appropriateness of those policies in accordance with applicable accounting standards. This process, known as auditing, adds credibility to financial reports.
  • Taxation: While often separate, accounting policies can influence taxable income. Companies must understand the interplay between financial accounting policies and tax regulations to ensure compliance and optimize tax planning.
  • Economic Research: Researchers at institutions like the Federal Reserve use insights from financial reporting and accounting policies to understand broader economic trends and inform monetary policy.2

Limitations and Criticisms

While essential for structured financial reporting, accounting policies are not without limitations or criticisms. One primary concern is the inherent flexibility allowed within established frameworks like GAAP or IFRS. This flexibility means that companies can choose among different acceptable policies, potentially leading to inconsistencies and difficulties in direct comparability between entities. For example, choices in depreciation methods or inventory valuation can impact reported earnings and asset values.

Another significant criticism revolves around the potential for earnings management. Although accounting policies aim to provide a true and fair view, management can sometimes select or change policies within permissible limits to present a more favorable financial picture, rather than purely reflecting economic reality. This can obscure underlying operational performance from investors. Concerns about accelerated revenue recognition, addressed by the SEC's SAB 101, highlight how certain policy applications can be misused to manipulate reported figures.1

Furthermore, the complexity of modern business transactions often outpaces the development of specific accounting policies, leading to judgment calls that can be subjective. The principle-based nature of IFRS, while offering flexibility, can sometimes result in less uniformity in practice compared to the more rule-based GAAP, though both systems have converged in many areas. The ongoing debate between principles-based and rules-based accounting standards highlights the challenge of creating policies that are both robust and adaptable to evolving business models.

Accounting Policy vs. Accounting Standard

While often used interchangeably, "accounting policy" and "accounting standard" refer to distinct but related concepts in financial reporting.

An accounting standard is an authoritative pronouncement issued by a standard-setting body (like FASB or IASB) that establishes the general principles and rules for how specific types of transactions and events should be accounted for. These standards provide the overarching framework and specific requirements that companies must follow. For instance, an accounting standard might dictate the conditions under which revenue can be recognized or how a lease should be classified.

An accounting policy, on the other hand, is the specific application of these broad accounting standards by an individual company. Within the confines of an accounting standard, there might be several permissible methods or treatments. The accounting policy chosen by a company is its specific selection from these available options, or its interpretation of how a general principle applies to its unique circumstances. For example, if an accounting standard allows for both the straight-line method and the reducing balance method of depreciation, a company's choice of one of these methods for its fixed assets constitutes its accounting policy for depreciation.

In essence, accounting standards set the boundaries and provide the menu of options, while accounting policies represent the specific choices made by a company within those boundaries. Companies must disclose their chosen accounting policies to provide transparency to users of their financial statements.

FAQs

Why are accounting policies important?

Accounting policies are important because they ensure consistency and comparability in a company's financial statements over time and across different companies. They provide a clear framework for how financial transactions are recorded and reported, enabling investors and other users to make informed decisions.

Who sets accounting policies?

Companies adopt their own accounting policies, but these policies must adhere to the broader rules established by authoritative accounting standard-setting bodies. In the U.S., this is primarily the Financial Accounting Standards Board (FASB) which sets Generally Accepted Accounting Principles (GAAP). Internationally, the International Accounting Standards Board (IASB) sets International Financial Reporting Standards (IFRS).

Where can I find a company's accounting policies?

A company's significant accounting policies are typically disclosed in the footnotes to its financial statements, often in the first or second footnote, titled "Summary of Significant Accounting Policies." These disclosures are a mandatory part of the financial report and provide detailed explanations of the methods used for various financial elements, such as inventory valuation and depreciation.

Can a company change its accounting policies?

Yes, a company can change its accounting policies, but usually only if the change is required by a new accounting standard or if it results in financial statements that are more reliable and relevant. Changes in accounting policy must be justified and typically require retrospective application, meaning prior period financial statements are restated as if the new policy had always been in effect, to maintain comparability.

What is the role of judgment in accounting policies?

Judgment plays a significant role in applying accounting policies, especially when transactions are complex or when specific guidance is not explicitly provided by accounting standards. Management must exercise professional judgment in selecting the most appropriate policy and making estimates that affect the financial statements. This is often where accrual accounting principles come into play, requiring estimations and allocations.