The procedures, rules, and standards used by a company's management in preparing and presenting the accounts or financial statements are called accounting policies. Accounting policies are not objective; rather, they are subjective. This means that there is no available list of such policies that an entity can use for all types of transactions. Rather, entities develop their policies based on their unique circumstances.
Thus they are different from one company to another, one industry to another industry. However, the policies must adhere to domestic and international accounting standards while also adhering to local laws and regulations. Accounting policies typically include measurement systems, accounting methods, and the method for presenting any disclosures.
Did you know? Accounting policies are different from accounting principles, as the principles are the overarching accounting rules, whereas policies are the way a company follows the rules.
Characteristics of Accounting Policies
The accounting policy is not objective, but rather subjective. There is no full list of all accounting policies used in every situation. Companies adopt appropriate alternative policy solutions based on their specific circumstances, primarily driven by extensive research and judgment by the company's management. The nature of policies must be such that they provide a true and fair picture of the business's financial circumstances. Furthermore, this must be applied thoroughly over year to ensure its consistency.
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Difference Between Accounting Principles and Accounting Policies
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Comparison of Conservative vs Aggressive Accounting Policies
Conservative accounting policies understate a company's current financial performance while demonstrating improved financial performance in subsequent years. It is a more sustainable approach that allows companies to improve over time, which is a good sign for investors.
Aggressive policies tend to employ accounting policies in such a way that they overstate a company's performance in previous years, resulting in a decline in a company's performance in subsequent years. Hence, If auditors or investors believe management is misrepresenting earnings or allocating costs, aggressive accounting policies may raise a red flag.
Stability of Accounting Policies
Unless a Standard or an Interpretation permits the categorization of items for which different policies may be appropriate, an entity shall select and apply its accounting policies consistently for similar transactions, other events, and conditions. If a Standard or an Interpretation requires or allows such categorization, an appropriate accounting policy must be chosen and applied to each category.
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How to select an Accounting Policy?
When deciding on an accounting policy, companies should remember that if a certain accounting standard applies to a transaction or occurrence, the accounting policy should be applied.
- During the policy development process, a corporation should look for comparable standards dealing with similar events and principles in the accounting framework addressing the treatment and meaning of assets, liabilities, income, and expenses. In addition, corporations may value the prudence idea, which stipulates that gains are not anticipated and are recognized only when realized. At the same time, provisions are made for any anticipated liabilities and losses.
- Policies must identify revenues as soon as possible. And to postpone spending for as long as feasible.
- Income Smoothing is another factor for adopting accounting policies. Revenue smoothing seeks to ease the flow of income. It is recommended that you first examine your earnings. Then, try to keep earnings variations to a minimum. This will reduce the risks associated with invested shares. As a result, your prospects of earning more money will improve. This criterion also proposes smoothing net income, revenues, and expenses.
- However, it should always be remembered that the accounting policy chosen should provide a precise and correct depiction of the company's financial affairs.
Restrictions on Accounting Policy Selection
A firm can try to adapt to a variety of policies. It does not imply that a company can choose a policy whenever it wants. It cannot abandon a policy if it no longer serves the firm's needs. Generally, a company compiles a set of policies as a permanent set. On the other hand, a secondary set is prepared to meet different needs. The techniques remain allowed even if a business splits its financial and income tax reports. The government entity just needs clear and intelligible reports about a company. The reports must be available for review. It should not conceal any previous debts that may cause problems in the future.
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Examples of Accounting Policies
Accounting policies revolve around principles, bases, conventions, rules, and practices applied by institutions for preparing and presenting financial statements. Let’s look into a few of them in detail.
Using Estimates
Preparing financial statements following Generally Accepted Accounting Principles (GAAP) necessitates management's application of accounting policies, reported amounts of assets, liabilities, income, and expenses, and disclosure of contingent liabilities on the date of the financial statements. Actual results may differ from those projections. Estimates and underlying assumptions are constantly evaluated. Any changes to accounting estimates are reflected in current and future periods.
Depreciation
Accounting firms use several techniques to calculate depreciation, such as the straight-line approach, the sum of the year's digits, the unit of output, and so on. Depreciation accounting policy would comprise expenses that can be capitalized, depreciation rate, disposal method, and so forth.
Inventory Assessment
Inventory is a key asset in every manufacturing or trading firm, and its valuation is critical. There are several ways to value inventory, including FIFO (First in, First Out), LIFO (Last in, First Out), the average cost method, and others.
Expenses for R&D
Many businesses struggle with determining whether or not to capitalize on R&D spending and which expenses must be included. As a result, it is critical that a corporation has suitable policies in place for tracking and recognizing such costs.
Recognizing Revenue
The policies must direct the organization on when to recognize revenue and when to recognize expenses. Furthermore, it must be obvious what all conditions must be met for revenue to be recognized.
Also Read: What is Negative Working Capital and How it Affects a Business?
Accounting Policy's Importance
These policies are essential to businesses, investors, and governments.
The following points will emphasize the significance of these policies to all stakeholders:
- Government check
All businesses must have policies that adhere to either GAAP or Indian Accounting standards. This enables the government to monitor the financial performance of enterprises and, as a result, defend the interests of investors.
- Giving investors a competitive advantage
By informing investors that they have followed specific accounting principles, investors will acquire increased confidence in the company and the statistics, and the statements can be easily compared to the financial statements of other companies.
- Disclosure
It is critical for businesses to disclose their policies. The disclosure will assist investors and outsiders in appropriately evaluating and interpreting the organization's financial strengths or weaknesses. Furthermore, it monitors whether or not a corporation follows its regulations consistently yearly.
- Correct framework
Accounting policies effectively provide organizations with a framework to publish their financial accounts uniformly.
Changes in Accounting Policies
The change in accounting policy can take place in a company in the following cases-
- If it is required by law or applicable standard
- If it results in a better presentation of the financial information by giving more reliable and relevant information.
Conclusion
In conclusion, accounting policies are critical in developing a framework for companies to follow when recording their day-to-day transactions. Furthermore, these policies aid in the preparation of financial statements. It is not incorrect to say that these policies serve as the foundation for an entity's accounting work. As a result, it is critical for a company to take all necessary time and precautions when developing its policies.
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