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.

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