Accounting Policies

Accounting policies are rules or guidelines that the company needs to adhere to while preparing and presenting its financial statements and therefore serve as a structure or framework for companies to follow.

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).

They are significant for the following reasons –

1. Proper framework: To articulate the company's financial affairs, it needs to prepare financial statements. And the financial statements prepared without any guidance would have no coherence within them. They help find out the coherence between financial statements. Accounting policy also offers a robust framework to follow so that the company may adhere to the right structure and prepare its financial statements.
2. Disclosure: A company must disclose what accounting policy they have been following. Since accounting standards represent items in many ways, proper accounting policy disclosure is essential.
3. Providing advantage to investors: If the companies mention the accounting policy they used to produce the financial statements, it will also help the investors. By stating the accounting policy, the companies ensure that they have maintained coherence while providing financial statements. This coherence helps the investors look at the financial statements and compare them with other companies from similar and different industries.
4. The government can keep a hold on the company's financial statements: All the financial statements prepared are as per the accounting policy, and companies always follow a proper structure. These companies also need to keep in mind that they can only follow the accounting policy made as per GAAP or IFRS. Thus, the government can have a direct hold on the company's financial statements, and the government can protect the interest of the investors.

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 principles 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 sales, 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 accounting, 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 Expensing.

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 profit. 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.

This has been a helpful guide to Accounting Policies along with Accounting policy examples and its significance. You may also like our suggested articles below -

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