What are Accounting Policies? With Key Elements and Examples

Introduction

Accounting policies are a set of formal rules and procedures that companies follow to ensure their financial records are accurate, consistent and comparable. These policies outline how to record, measure, and present financial information. Whether you’re a small business or a large corporation, adhering to accounting policies is essential for transparency, compliance with legal standards, and informed decision-making.

In this blog, we’ll explore the basics of accounting policies, dive into their key elements, and provide examples to help you understand how they work in practice. We’ll also look at important distinctions, such as accounting principles vs. policies, and conservative vs. aggressive accounting approaches.

What Are Accounting Policies?

Accounting policies are rules and procedures that companies use to manage and report their financial activities. These policies help ensure that financial statements are prepared consistently over time, making it easier for investors, regulators, and other stakeholders to understand a company’s financial health. 

Accounting policies determine how companies value assets, recognize revenue, and estimate expenses. In simple terms, accounting policies are like a set of instructions that companies follow to make sure their financial reports are accurate and standardized across different periods.

Key Elements in Accounting Policies

Several key elements make up accounting policies. These elements ensure that companies apply consistent standards while preparing their financial reports. Some important ones include:

1. Revenue recognition – Defines when and how a company should record income in its books.

   Example: Recording sales revenue when control of goods is transferred to the customer, such as the goods being received by the customer. 

2. Asset valuation – Explains how to determine the value of assets like inventory and equipment.

   Example: Companies can use the historical cost or fair value method to determine the asset value.

3. Expense recognition – Guides when and how expenses should be recorded in the books.

   Example: Recording the depreciation expense of an equipment over its useful life.

4. Depreciation methods – Specifies the method used to allocate the cost of assets over their useful lives. 

   Example: Companies can use various depreciation methods, such as straight-line depreciation, units of production depreciation, or double declining balance depreciation.

5. Inventory Valuation – Definesmethods to assess inventory cost, affecting profit margins and financial statements.

   Example: Companies can use various methods, such as First-In, First-Out (FIFO), Last-In, First-Out (LIFO), or average cost, to determine inventory value.

These elements together ensure that financial information is reported in a uniform and reliable way, giving a clear picture of the company’s financial position.

How Are Accounting Policies Used?

Accounting policies guide companies in preparing their financial statements, especially when dealing with complex accounting tasks like depreciation, inventory valuation, or consolidating accounts. While the exact policies may differ from one company to another, they must follow broader accounting standards, such as Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).

Management has some flexibility when choosing specific accounting policies, which can impact how a company reports its financial performance. Investors and auditors often examine these policies to assess whether a company is being conservative or aggressive in its reporting.

Example of an Accounting Policy

Let’s look at a simple example of an accounting policy related to inventory valuation. A company can choose between two main methods: First-In, First-Out (FIFO) or Last-In, First-Out (LIFO) although LIFO is not permitted under IFRS.

With FIFO, the first items purchased are recorded as sold first, which can result in lower costs during periods of rising prices, hence higher profits. In contrast, LIFO assumes that the latest inventory is sold first, potentially increasing costs and reducing profits. This decision directly impacts the company’s profit margins, tax liabilities, and financial statements, demonstrating how accounting policies affect overall financial reporting.

To better understand, let’s take a company, XYZ, which uses the First-In, First-Out method for inventory valuation. Company XYZ purchases 10 units of inventory at $10 each in the first half of the month and 10 more at $12 each in the second half. Over the month, XYZ sells 15 units in total.

Under the FIFO method, its cost of goods sold (COGS) will be calculated as: (10 x $10) + (5 x $12) = $160. 

Under the LIFO method its COGS will be higher: (10 x $12) + (5 x $10) = $170. 

Alternatively, under the Average Cost method, the COGS would be: (15 x $11) = $165, where $11 is the average of $10 and $12.

In periods of rising prices, a company can strategically choose the inventory valuation method based on the organization’s financial strategy. They can either increase profits using FIFO or utilize LIFO to increase COGS and reduce tax liabilities. 

What Is the Difference Between Accounting Policies and Principles?

Accounting principles are broad guidelines that govern the entire accounting process. They are the foundation upon which financial reporting is built, ensuring consistency, reliability, and comparability across different companies. Principles such as the accrual principle, revenue recognition, and the matching principle apply to most businesses and are part of frameworks like GAAP and IFRS.

Accounting policies, on the other hand, are the specific methods and procedures a company adopts within these principles. While principles provide the framework, policies allow for flexibility within these frameworks. For example, a company may choose between different inventory valuation methods (like FIFO or LIFO under GAAP) under the broad principle of accurate financial reporting.

In essence, principles set the rules, while policies are the choices a company makes to implement those rules in a way that best suits its operations.

What Is the Difference Between Conservative and Aggressive Accounting?

Conservative accounting involves using accounting methods that result in lower reported profits and higher expenses. Companies adopting this approach aim to understate earnings and overstate liabilities, ensuring they don’t overestimate their financial health. This method provides a more cautious view of the company’s performance, which can help avoid financial surprises in the future.

On the other hand, aggressive accounting is the practice of using methods that inflate earnings and minimize expenses, providing a more optimistic overview of a company’s financial position. This approach may involve early revenue recognition or underestimating future expenses, which might misrepresent the financial health of the organization and mislead investors and other stakeholders.

How Can Highradius Help Improve Your Financial Reporting

Accurate financial statements are crucial for reliable accounting policies and reporting. Before delving into more detailed analysis, it’s essential to ensure that these statements reflect your company’s financial health accurately.

Accurate reconciliations play a key role in ensuring this accuracy. Accounting teams carefully compare general ledger (GL) balances with internal sources like sub-ledgers and external sources such as bank statements. HighRadius’ Account Reconciliation Software enhances this process by leveraging AI and machine learning to automate reconciliations, improving productivity by 50%. Our Transaction Matching module automatically aligns transactions from various data sources, achieving up to a 90% auto-match rate, which saves time and minimizes errors.

Additionally, HighRadius’ Close Checklist ensures all steps in the financial close process are completed accurately, further enhancing reliability. This thorough approach helps identify and resolve discrepancies quickly, as the requisite task list is noted and addressed promptly, ensuring that your financial statements are dependable.

By incorporating these advanced solutions, such as Financial Close Management Software, you can refine your financial close process, improve the accuracy of your statements, achieve a 30% reduction in days to close, and gain valuable insights into your company’s financial status. Prioritizing accuracy in your accounting policies and procedures ensures a true and reliable picture of your financial health.

FAQs

1. How to write accounting policies and procedures?

To write accounting principles and procedures, you must start by defining the policy’s purpose and scope. Outline specific procedures for recording and reporting financial transactions. Ensure compliance with accounting standards. Document responsibilities and approval processes. Regularly review and update as needed.

2. What are the five accounting policies?

5 accounting policies are, Revenue Recognition, determines when income should be recorded; Asset valuation, specifies how to value assets; Expense recognition, outlines how expenses should be recorded; Depreciation methods, allocates the cost of an asset over its useful life; and Inventory valuation, includes FIFO and LIFO.

3. What are accounting policies and procedures?

Accounting policies are rules guiding financial reporting that are individual to every organization, while procedures are steps to apply these rules, which are specified by the country in which the organization operates. Together, they ensure consistent and accurate financial statements compliant with accounting standards.

4. What are accounting policies examples?

Examples of accounting policies are FIFO for inventory valuation, that assumes that the oldest inventory is sold first, straight-line depreciation for spreading the cost of an asset evenly over its useful life. These policies ensure consistency in financial reporting by providing standardized methods for recording transactions.