Accounting Policies

What are 'Accounting Policies'

Accounting policies are the specific principles, rules and procedures implemented by a company's management team and are used to prepare its financial statements. These include any methods, measurement systems and procedures for presenting disclosures. Accounting policies differ from accounting principles in that the principles are the accounting rules and the policies are a company's way of adhering to those rules.

BREAKING DOWN 'Accounting Policies'

Accounting policies are a set of standards that govern how a company prepares its financial statements. These policies are used to deal specifically with complicated accounting practices such as depreciation methods, recognition of goodwill, preparation of research and development costs, inventory value and the consolidation of financial accounts. These policies may differ from company to company, but all accounting policies are required to conform to Generally Accepted Accounting Principles (GAAP) and/or International Financial Reporting Standards (IFRS).

Accounting policies can be thought of as a framework in which a company is expected to operate; however, the framework is somewhat flexible, and a company's management team can choose specific accounting policies that are advantageous to the financial reporting of the company.

An Example of Accounting Policies

Accounting policies can be used to legally manipulate earnings. For example, many companies are allowed to report inventory using either the first-in, first-out (FIFO) method or the last-in, first-out (LIFO) method of accounting. With FIFO, when a company sells a product, the inventory produced first is considered sold. With LIFO, when a product is sold, the last inventory produced is considered sold. In periods of rising inventory prices, a company can use one of these accounting policies to increase its earnings.

Continuing the example above, a company in the manufacturing industry buys inventory at $10 per unit for the first half of the month and $12 per unit for the second half of the month. The company ends up purchasing a total of 10 units at $10 and 10 units at $12, and sells a total of 15 units for the entire month. If the company uses FIFO, its cost of goods sold is: (10 x $10) + (5 x $12) = $160. If, however, it uses LIFO, its cost of goods sold is: (10 x $12) + (5 x $10) = $170. It is therefore more advantageous to have a FIFO method in periods of rising prices.

The Importance of Understanding a Company's Accounting Policies

Accounting principles are lenient at times, and the specific policies of a company are very important. Looking into a company's accounting policies can signal whether management is conservative or aggressive when reporting earnings. This should be taken into account by investors when reviewing earnings reports. Also, outside accountants who are hired to review a company's financial statements should check the company's policies to ensure they conform to standard accounting principles.

RELATED TERMS
  1. Accounting Change

    A change in accounting principles, accounting estimates, or the ...
  2. Accounting Principles

    The rules and guidelines that companies must follow when reporting ...
  3. First In, First Out - FIFO

    An asset-management and valuation method in which the assets ...
  4. LIFO Reserve

    The difference between the FIFO and LIFO cost of inventory for ...
  5. Accounting Standard

    A principle that guides and standardizes accounting practices. ...
  6. First In, Still Here - FISH

    An accounting buzzword that describe when companies still have ...
Related Articles
  1. Investing

    Inventory Valuation For Investors: FIFO And LIFO

    We go over these methods of calculating this component of the balance sheet, and how the choice affects the bottom line.
  2. Investing

    What are Accounting Principles?

    The term accounting principles refers to rules and guidelines companies use to help them record their business and financial transactions.
  3. Investing

    When & Why Should a Company Use LIFO

    By using LIFO (last in, first out) when prices are rising, companies reduce their taxes and also better match revenues to their latest costs.
  4. Investing

    Why Last In First Out Is Banned Under IFRS (XOM)

    We explain why Last-In-First-Out is banned under IFRS
  5. Investing

    GAAP

    Learn more about the generally accepted accounting principles, standards and procedures that companies use to compile their financial statements.
  6. Entrepreneurship & Small Business

    Understanding First In, First Out (FIFO)

    A company that uses the first in, first out inventory valuation method will sell, use, or dispose of assets that it produced or acquired first.
  7. Investing

    Inventory: FIFO, LIFO

    Whether a company chooses FIFO or LIFO has important implications for the bottom line and for tax liability.
  8. Investing

    How to Analyze a Company's Inventory

    Discover how to analyze a company's inventory by understanding different types of inventory and doing a quantitative and qualitative assessment of inventory.
  9. Managing Wealth

    Accountant: Job Description & Average Salary

    Discover what the job description of an accountant entails, along with education and training, salary and skills necessary for success.
  10. Markets

    What is Accounting?

    Accounting is the recording of financial transactions of a business or organization. It also includes the process of summarizing, analyzing and reporting these transactions in financial statements.
RELATED FAQS
  1. Does US GAAP prefer FIFO or LIFO accounting?

    Investigate the use of LIFO and FIFO inventory accounting methods under U.S. GAAP, and learn why there is pressure from some ... Read Answer >>
  2. What are the business consequences of using FIFO vs. LIFO accounting methods?

    Learn about the real business consequences from using a first-in, first out inventory accounting method versus a last-in, ... Read Answer >>
  3. What are the disadvantages of the FIFO accounting method?

    Learn how the FIFO accounting method differs from the LIFO method and the primary disadvantages for a company using the FIFO ... Read Answer >>
  4. How should a change in accounting principle be recorded and reported?

    Learn about changes in accounting principle and why businesses make them, as well as the reporting and recording requirements ... Read Answer >>
  5. What are the differences between a change in accounting principle and a change in ...

    Learn how to differentiate between a change in accounting principle and a change in accounting estimate and how accountants ... Read Answer >>
  6. What's the difference between weighted average accounting and FIFO/LILO accounting ...

    The main difference between weighted average cost accounting, LIFO, and FIFO methods of accounting is the difference in which ... Read Answer >>
Hot Definitions
  1. European Union - EU

    A group of European countries that participates in the world economy as one economic unit and operates under one official ...
  2. Sell-Off

    The rapid selling of securities, such as stocks, bonds and commodities. The increase in supply leads to a decline in the ...
  3. Brazil, Russia, India And China - BRIC

    An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...
  4. Brexit

    The Brexit, an abbreviation of "British exit" that mirrors the term Grexit, refers to the possibility of Britain's withdrawal ...
  5. Underweight

    1. A situation where a portfolio does not hold a sufficient amount of a particular security when compared to the security's ...
  6. Russell 3000 Index

    A market capitalization weighted equity index maintained by the Russell Investment Group that seeks to be a benchmark of ...
Trading Center