What are accounting policies?
Accounting policies are the specific methods and procedures a company’s management applies when preparing its financial statements. They spell out how the firm measures, records, and presents items such as revenue, inventory, depreciation, research and development costs, goodwill, and the consolidation of subsidiaries. Accounting policies must comply with the governing rule set—typically U.S. GAAP (Generally Accepted Accounting Principles) or IFRS (International Financial Reporting Standards)—but within those frameworks management often has choices about which methods to use.
Key definitions
– Accounting principle: a standardized rule or framework (for example, GAAP or IFRS) that guides accounting practice.
– Accounting policy: a management-selected method or procedure used to apply those principles in preparing the company’s financial statements.
– Conservative accounting: policy choices that tend to report lower profits or higher expenses in the short term (more cautious recognition of income or more ready recognition of losses).
– Aggressive accounting: policy choices that increase reported earnings or reduce reported expenses in the short term (more liberality in recognizing income or deferring losses).
Why accounting policies matter
– They determine how transactions affect reported revenue, expenses, assets and liabilities.
– They can materially change key metrics such as gross profit, net income, and equity even when the underlying economic events are identical.
– They must be disclosed (usually in the footnotes to financial statements), and auditors review them for conformity with the applicable standard-setter.
– Investors and analysts scrutinize policies to gauge earnings quality and whether management is conservative or aggressive.
Common examples of accounting policies
– Inventory valuation method: FIFO (first-in, first-out), LIFO (last-in, first-out — allowed under U.S. GAAP but not under IFRS), or weighted average cost.
– Depreciation method: straight-line vs accelerated (e.g., double-declining-balance).
– Revenue recognition timing and method.
– Capitalization vs expensing of R&D costs.
– Fair value measurement and impairment testing.
– Lease accounting and consolidation criteria.
Worked numeric example — inventory valuation (illustrates effect on cost of goods sold and gross profit)
Assumptions
– Purchases during period: 10 units at $10 each, and later 10 units at $12 each (total 20 units).
– Units sold during period: 15 units.
– Selling price per unit: $25 (assumed to show profit impact).
Compute cost of goods sold (COGS) and gross profit under three methods:
1) FIFO (first units purchased are recognized as sold first)
– COGS = (10 × $10) + (5 × $12) = $100 + $60 = $160
– Revenue = 15 × $25 = $375
– Gross profit = $375 − $160 = $215
2) Weighted average cost
– Average cost per unit = [(10 × $10) + (10 × $12)] / 20 = ($100 + $120) / 20 = $11.00
– COGS = 15 × $11 = $165
– Gross profit = $375 − $165 = $210
3) LIFO (latest purchases are recognized as sold first)
– COGS = (10 × $12) + (5 × $10) = $120 + $50 = $170
– Gross profit = $375 − $170 = $205
Interpretation: with rising purchase prices in this example, FIFO produces the lowest COGS and highest gross profit; LIFO produces the highest COGS and lowest gross profit. In periods of rising costs, a company that wants to show higher current profits (and thus possibly higher earnings per share) may favor FIFO; a company seeking lower taxable income may use LIFO (where permitted).
Checklist: how to assess a company’s accounting policies
1. Read the accounting policies note in the annual report or 10-K (footnotes).
2. Identify key choices: inventory method, revenue recognition, depreciation, R&D treatment, leasing/consolidation rules.
3. Check for policy changes year over year and read management’s rationale.
4. Look for significant accounting estimates and judgments (impairments, fair-value inputs, warranty reserves).
5. Compare methods to industry peers (are they consistent or outliers?).
6. Consider tax implications (e.g., LIFO vs FIFO under U.S. rules).
7. Review the auditor’s opinion and any emphasis-of-matter paragraphs about accounting policies.
8. Test sensitivity: estimate how metrics (net income, margins, ROE) would shift under alternative reasonable methods.
Conservative vs aggressive choices — what to watch for
– Conservative choices: earlier recognition of losses, later recognition of revenue, higher provisions and write-downs. These typically depress near-term profit but may reduce future restatements and offer smoother long-term performance.
– Aggressive choices: earlier revenue recognition, capitalizing costs that could be expensed, choosing methods that lower current expenses. These can inflate short-term results but increase the risk of future earnings reversals or regulatory scrutiny.
Practical notes and assumptions
– Accounting policies are management choices made within the constraints of the applicable accounting standards. Different jurisdictions have different allowed methods (for example, IFRS does not permit LIFO for inventory valuation).
– Policies must be disclosed clearly so users of financial statements can evaluate comparability and quality.
– Auditors examine whether the selected policies are applied consistently and conform to GAAP or IFRS.
Selected reputable references
– Financial Accounting Standards Board (FASB) — About the FASB: https://www.fasb.org
– U.S. Securities and Exchange Commission (SEC) — Company filings and reporting guidance: https://www.sec.gov
– IFRS Foundation / IASB — International Financial Reporting Standards: https://www.ifrs.org
– Investopedia — Accounting policies overview (general primer): https://www.investopedia.com/terms/a/accounting-policies.asp
Educational disclaimer
This explainer is for educational purposes only and does not constitute personalized investment, accounting, or tax advice. For decisions about a specific company or transaction, consult a qualified advisor or the company’s audited financial statements and disclosures.