Introduction

Every business organisation has its organisational motives. They select appropriate accounting policies to disclose their accounting statements and accomplish their motives. Any investor should be provided with complete information about organisational financial position before they invest, as this helps them interpret the organisation’s standard. 

The concept of accounting policies & accounting principles is different. Accounting principles refer to considering the accounting rules of the company, whereas accounting policies refer to the system and method by which the company follows the accounting rules.

Though the accounting policies differ across companies and geographies, the most common generally followed accounting standards are:

  • Generally Accepted Accounting Principles (GAAP) 
  • International Financial Reporting Standards (IFRS). 

Accounting Policies used by the Companies

The accounting policies used by the companies differ based on the industry they operate in. Some of the primary vital policies which the companies use are as follows:

  • Valuation of fixed assets – This process determines the fair market value of an asset. 
  • Depreciation and inventory policies – This method determines the cost of the goods produced by the company and the inventory purchases. Depreciation policy refers to allocating costs for an asset over its estimated life. 
  • Valuation of investments – Refers to the specific value of the asset to corresponding parameters.
  • Translation of foreign currency items – Refers to the process in which the company’s financial statements are denominated in foreign currencies.
  • Costs incurred for research and development – Refers to the cost incurred for acquiring new knowledge and the related process to convert the ability into new products.
  • Historical or current cost accounting – Refer to the process in which the item’s original cost and current value are periodically updated and recorded.
  • Treatment of leases – Refers to the process where leases are considered a financial liability and recorded as operating expenses.
  • Recognition of profits on long-term contracts– Refers to the process of recording the revenue over the completed contract method.
  • Treatment of contingent liabilities – Expenses related to an outcome of a future event are estimated & recorded as a liability. 

Importance of Accounting Policies

Accounting Policies are essential:

  • for a company to prepare financial statements, 
  • for an investor to ascertain the standard of the company so they can be confident to invest and
  • for a government to establish the financial standing of the economic basis of the company’s performance.

Other primary reasons and importance of accounting policies are as follows:

  • Establishment of a standardised framework

Accounting policies provide a standardised format for the companies to be used to report their financial statements.

  • Confidence to the investors

Investors gain confidence in the company as numbers can be easily compared when the company follows particular accounting policies.

  • Check on financial statements

When companies follow GAAP or IFRS accounting standards to prepare their financial statements, it enables the government to check the company’s financial statements. Also, the interest of the investors can be protected. 

Examples of Accounting Policy

A few examples where the companies apply accounting policies are as follows: 

  • Valuation of Inventory 

The company chooses definite accounting policies like the FIFO method, LIFO method, or average cost method for the valuation of inventory. 

  • Depreciation

Companies use different accounting policies to calculate depreciation. The following is an example of an accounting policy to calculate depreciation, a straight-line method – This is most common in practice. More examples of accounting policy to calculate depreciation include the double-declining method, sum of year’s digits, unit of production, etc.

  • Revenue and Expenses 

Significant accounting policies related to Revenue and Expenses claim that revenue can be recognized only after the customer receives the goods and services. The customer shall sign the proof of receipt, which stands as evidence of revenue. This example of accounting policy is recorded as revenue recognition in the financial statement. 

Uses of Accounting Policies

Major uses of Accounting Policies are as follows:

  • Serves as a command to the company’s management to prepare the financial statements.
  • It serves as a ready reference for similar past instances of the company.
  • Helps to maintain consistency of financial statement
  • It facilitates easy comparison with previous year data or with other organizations.
  • Helps investors to analyse the financial statements & then decide to invest or decline investment.

Conclusion

Accounting policies provide a set of rules and procedures which a company is expected to follow to record the      daily transaction, measure its      assets and liabilities, and make its financial statements. Accounting policies are a fundamental part of every business as they are the basis on which the financial statements are prepared. Following them as intended is essential as it facilitates maintaining consistency. Effective usage of accounting policies also increases investors’ and shareholders’ confidence and trust in the business.