Accounting policies

Accounting Policies

Accounting policies are the specific principles, bases, conventions, rules, and procedures adopted by a company in preparing and presenting its financial statements. They are the framework used to consistently record and report financial information, ensuring comparability and transparency. Understanding accounting policies is crucial for anyone analyzing a company’s financial health, including investors, creditors, and regulators. This article provides a comprehensive overview of accounting policies for beginners, covering their importance, common examples, selection, disclosure, and changes.

Why are Accounting Policies Important?

Accounting policies directly impact the numbers reported on a company’s balance sheet, income statement, cash flow statement, and statement of changes in equity. Different policies can lead to significantly different financial results, even for the same underlying economic events. Therefore, understanding the policies used is paramount for accurate financial analysis.

Comparability: Consistent application of accounting policies allows for comparison of a company’s financial performance over time and with its competitors. Without standardized policies, analysis would be difficult and potentially misleading.
Transparency: Disclosure of accounting policies provides stakeholders with insight into how financial information is measured and reported, enhancing trust and accountability.
Decision-Making: Investors and creditors rely on financial statements to make informed decisions. Understanding the accounting policies used is essential to properly interpret the reported results.
Compliance: Companies are required to adhere to accounting standards (like Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS)), which provide a framework for developing and applying accounting policies. Failure to comply can lead to penalties and reputational damage.
Accurate Valuation: Policies dictate how assets and liabilities are valued, influencing the reported net worth of the company. Considerations include depreciation methods, inventory valuation, and impairment losses.

Common Accounting Policy Examples

Numerous accounting policies cover various aspects of financial reporting. Here are some of the most common:

Revenue Recognition: This policy determines *when* revenue is recognized. Different methods exist, including recognizing revenue when cash is received (cash basis) or when earned (accrual basis). IFRS 15 and ASC 606 provide detailed guidance on revenue recognition, impacting industries like software, subscription services, and retail.
Inventory Valuation: This policy dictates how the cost of inventory is determined. Common methods include:

   *   First-In, First-Out (FIFO): Assumes the first units purchased are the first ones sold.
   *   Last-In, First-Out (LIFO): Assumes the last units purchased are the first ones sold (permitted under GAAP, but not IFRS).
   *   Weighted-Average Cost: Calculates a weighted average cost based on the total cost of goods available for sale divided by the total number of units available.
   *   Lower of Cost or Market: Inventory is reported at the lower of its cost or its current market value.  This impacts gross profit margins.

Depreciation Methods: This policy determines how the cost of a fixed asset (like machinery or buildings) is allocated over its useful life. Common methods include:

   *   Straight-Line:  Depreciates the asset equally over its useful life.
   *   Declining Balance:  Applies a higher depreciation expense in the early years of the asset’s life.
   *   Units of Production:  Depreciates the asset based on its actual usage.  This is common in manufacturing.

Amortization of Intangible Assets: Similar to depreciation, but applies to intangible assets like patents or copyrights.
Impairment of Assets: This policy addresses how to recognize a loss in value of an asset. IFRS and GAAP have specific rules for identifying and measuring impairment losses. This is crucial for assessing asset quality.
Accounting for Leases: IFRS 16 and ASC 842 have significantly changed lease accounting, requiring most leases to be recognized on the balance sheet as right-of-use assets and lease liabilities.
Accounting for Financial Instruments: Policies cover the classification, measurement, and disclosure of financial assets and liabilities, including stocks, bonds, and derivatives. This is particularly relevant for financial institutions.
Foreign Currency Translation: This policy determines how transactions in foreign currencies are translated into the company’s reporting currency. This impacts companies with international operations.
Income Tax Accounting: Policies relate to the recognition and measurement of income tax expense, including deferred tax assets and liabilities.
Provisions and Contingencies: Policies govern the recognition of liabilities for uncertain future events. This includes estimates for warranty obligations and legal claims.

Selecting Accounting Policies

Companies aren't entirely free to choose any policy they want. They must select policies that:

Comply with Applicable Accounting Standards: GAAP or IFRS provide a framework, and policies must be consistent with these standards.
Reflect the Economic Substance of Transactions: Policies should accurately represent the underlying economic reality of the company’s activities.
Be Consistently Applied: Once a policy is chosen, it should be applied consistently from period to period to ensure comparability. Changes in accounting policies (discussed below) require justification and disclosure.
Be Appropriate for the Industry: Certain industries have specific accounting practices that are commonly followed. For example, the oil and gas industry has unique accounting rules for exploration and production costs.
Consider the Company's Specific Circumstances: Policies should be tailored to the company’s unique business model and operations.

The selection process often involves judgment and consultation with accounting professionals. A company’s audit committee plays a vital role in overseeing the selection and application of accounting policies.

Disclosure of Accounting Policies

Transparency is key. Companies are required to disclose their significant accounting policies in the notes to the financial statements. These disclosures should include:

A summary of the significant policies: A clear and concise explanation of the policies used.
The methods used to account for specific items: For example, the method used to calculate depreciation or value inventory.
The judgments and estimates made in applying the policies: Accounting often involves estimates (like the useful life of an asset), and these should be disclosed.
The impact of changes in accounting policies: If a policy is changed, the impact on the financial statements should be disclosed (see section below).

These disclosures allow stakeholders to understand how the financial statements were prepared and to assess the reliability of the reported information. Proper disclosure is crucial for maintaining investor confidence and avoiding potential legal issues. Companies often use a dedicated section titled "Summary of Significant Accounting Policies" in the notes.

Changes in Accounting Policies

Accounting policies aren’t set in stone. Changes can occur for several reasons:

New Accounting Standards: Accounting standards are constantly evolving, and companies must adopt new standards when they become effective.
Changes in Circumstances: A company’s business model or operations may change, requiring a change in accounting policies.
Improved Accounting Practices: A company may identify a more appropriate or accurate way to account for certain transactions.

However, changes in accounting policies are not taken lightly. They should only be made if justified and must be disclosed in the financial statements. The disclosure should include:

The nature of the change: A clear explanation of the change in policy.
The reasons for the change: Why the change was necessary or beneficial.
The impact of the change on the financial statements: How the change affected the reported results. This often involves restating prior period financial statements to ensure comparability (known as retrospective application).
Any cumulative effect of the change on retained earnings: The impact of the change on the company’s accumulated profits.

Changes in accounting policies can signal a significant event for a company. Investors should carefully review these disclosures to understand the implications of the change. Some changes require prospective application, meaning they only affect future periods.

The Role of Professional Judgment

While accounting standards provide guidance, they often require professional judgment. For example, determining the useful life of an asset or estimating the probability of collecting an account receivable requires careful consideration of the specific facts and circumstances. Accountants must exercise due professional care and objectivity when applying accounting policies. This is where understanding fundamental analysis and the company’s business model becomes critical.