Accounting Policies Details

The International Financial Reporting Standards (IFRS) and the Generally Accepted Accounting Principles (GAAP) are accounting principles that guide how businesses can file their financial statements. IFRS is more principle-based and can better show the economics of a transaction. GAAP is a more rule-based approach. The difference between the two methods is evident in the different accounting policy principles. Some accounting policies that are allowed under GAAP, IFRS may not permit.

Companies in different geographies operate with varying accounting policies; it is the same for companies operating in various industries. Most firms adopt one of the two accounting guidelines, the Generally Accepted Accounting Principles (GAAP) or the International Financial Reporting Standards (IFRS). Accounting policies are different from accounting principles, while policies are the way a business follows the rules.

Some key accounting policies are:

  • Conventions on accounting followed
  • Fixed asset value
  • Policies on depreciation and inventory
  • Investments valuation
  • Foreign Currency Products Translation
  • Costs incurred for production and analysis
  • Historical or Current accounting for expenses
  • Treatment of rental contracts
  • Goodwill Care
  • Benefit recognition on long-term contracts
  • Dealing with contingent liabilities

There are two types of accounting policies. They are

  • Conservative Policies: Conservative accounting policies look into the company's current financial performance and show better financial performance in subsequent years. It is a more sustainable approach and allows companies to show improvement over the years, which is a positive sign for investors.
  • Aggressive Policies: Aggressive policies tend to employ accounting policies that overstate performance in earlier years, leading to a decline in corporate performance in later years. Aggressive accounting policies can set off red flags with auditors or investors if they feel that management distorts profits or allocates costs.

Example of Accounting Policies

Assume that an entrepreneur owns a shirt factory. The selling price of a shirt is $50. Last month, he bought 100 shirts for $10, then he purchased another batch of 100 shirts for $20.

The owner sold 30 shirts during the month. His gross revenues, irrespective of the accounting procedure, will be $1,500 ($50 x 30 shirts).

If the owner used the First In First Out (FIFO) approach, the cost of goods sold for shirts would be $300 ($10 x 30 shirts) with a net income of $1,200 ($1,500 - $300). Under Last In First Out (LIFO), the cost of goods sold would be $600 ($20 x 30 shirts). With $900 ($1,500 - $600) as the net income.

The highest net income will come from the FIFO process, as the cost of goods sold is the lowest. It helps us understand how an organization can use various accounting practices to make the most of its earnings.

Significance of Accounting Policies

There are several reasons why accounting policies are of the utmost importance to the company, the investor, and the government.

  • Government Regulation: All companies should follow either GAAP or IFRS when preparing their financial statements. This is a way in which the government can monitor financial statements and simultaneously protect investors' interests.
  • Standardized Format: Accounting policies essentially provide a framework for companies to report their financial statements to follow a standardized format across the board.
  • Advantageous for Investors: Investors will gain added confidence in the company and the reported financials. Additionally, investors can easily compare the statements to other companies' financial statements.
  • Disclosure: A business must report the accounting practices that it follows. Policies contain separate guidelines for reporting information to investors, and companies should comply with appropriate disclosure standards.