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. LIFO Reserve

    The difference between the FIFO and LIFO cost of inventory for ...
  2. Average Cost Method

    The average cost method is an inventory costing method in which ...
  3. LIFO Liquidation

    When a company using the LIFO (Last In, First Out) method of ...
  4. Accounting Principles Board - APB

    The Accounting Principles Board is the prior authoritative body ...
  5. Highest In, First Out - HIFO

    Highest in, first out is an inventory distribution method where ...
  6. Tax Accounting

    Accounting methods that focus on taxes rather than the appearance ...
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

    GAAP

    Learn more about the generally accepted accounting principles, standards and procedures that companies use to compile their financial statements.
  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. Insights

    What You Should Know About Inflation

    Find out how this figure relates to your investment portfolio.
  5. Investing

    Understanding Periodic vs. Perpetual Inventory

    An overview of the two primary inventory accounting systems.
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. 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 >>
  4. 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 >>
  5. How can the first-in, first-out (FIFO) method be used to minimize taxes?

    Understand what the FIFO inventory method is and how it can be used to minimize taxes. Learn why it would also decrease overall ... Read Answer >>
  6. What are some of the basic Generally Accepted Accounting Principles?

    Learn more about generally accepted accounting principles determined by the Financial Accounting Standards Board, including ... Read Answer >>
Hot Definitions
  1. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
  2. Financial Industry Regulatory Authority - FINRA

    A regulatory body created after the merger of the National Association of Securities Dealers and the New York Stock Exchange's ...
  3. Initial Public Offering - IPO

    The first sale of stock by a private company to the public. IPOs are often issued by companies seeking the capital to expand ...
  4. Cost of Goods Sold - COGS

    Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold in a company.
  5. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and expenses incurred during a specified period of time, usually ...
  6. Monte Carlo Simulation

    Monte Carlo simulations are used to model the probability of different outcomes in a process that cannot easily be predicted ...
Trading Center