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Accounting Policies: Definition, Importance & Examples

Updated: November 17, 2022

Accounting policies are a set of guidelines. They define the rules and standards for measuring financial information. These policies can be broadly classified as conservative or aggressive. There are also other factors to consider. These include International Financial Reporting Standards (IFRS) or Generally Accepted Accounting Principles (GAAP). Here is an introduction to critical accounting conventions, what they mean and much more.

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    KEY TAKEAWAYS

    • Small businesses do not have to adopt accounting methods. It is still a good idea to have some basic guidelines in place.
    • Accounting policies are important. They set out the rules by which a company reports its financial information.
    • Good accounting policies provide a framework. Within this framework, financial statements can be accurately prepared.
    • Disclosure of accounting policies can also provide investors with a valuable advantage.
    • New accounting policies are released all the time. However, the most common ones are GAAP and IFRS.

    What is Meant by Accounting Policies?

    Policies refer to the written guidelines that a company adopts to govern the financial reporting process. They set out the specific rules and auditing standards for measuring financial condition. The policies may be classified as conservative or aggressive. This depends on how they approach financial reporting. For example, a conservative policy may require entities to adopt a more cautious approach. This can be important when estimating future income or assets.

    There are also other factors to consider when classifying accounting policies. For instance, some businesses may follow International Financial Reporting Standards (IFRS). Other companies may adhere to Generally Accepted Accounting Principles (GAAP). There are other prominent accounting policies which International businesses often follow.

    No matter which policy a business chooses to follow, it is important to understand and adhere to the specific guidelines. This will ensure that financial statements are accurately measured and fairly represented.

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    IFRS vs GAAP

    There are two main types of accounting policies.

    1. International Financial Reporting Standards (IFRS). IFRS is the global standard for financial reporting.
    2. Generally Accepted Accounting Principles (GAAP). GAAP is the standard in the United States.

    While there are some similarities between the two, there are also some key differences. Here is a brief summary of each.

    1. IFRS

    • IFRS is a set of global standards that businesses must adhere to when preparing their financial statements. They were developed by the International Accounting Standards Board (IASB).
    • Generally, IFRS are more principles-based than GAAP. This means that there is more room for interpretation when following these guidelines.
    • IFRS allows companies to use estimation techniques to calculate certain figures. This is not allowed under GAAP.
    • IFRS are less prescriptive than GAAP. This means that businesses have more freedom in how they report their financial information.

    2. GAAP

    • GAAP is the standard accounting framework in the United States. It was created by the Financial Accounting Standards Board (FASB).
    • GAAP is more rules-based than IFRS. This means that there is less room for interpretation when following these guidelines.
    • GAAP prohibits companies from using estimation techniques to calculate certain figures. This is allowed under IFRS.
    • GAAP is more prescriptive than IFRS. This means that businesses have less freedom in how they report their financial information.

    What Are Some Other Examples of Accounting Policies?

    There are a variety of different accounting policies that businesses may adopt. The most common policies include:

    1. Revenue Recognition Policy

    This policy sets out the rules for recognizing revenue in financial statements. The time when revenues are recognized on your firm’s income statement is known as the accounting period. If you are using the accrual basis, revenue recognition will only occur in the reporting period if you are utilizing a software program that supports it. On a cash basis, your company will only record revenue when cash is actually received.

    2. Cost Principle

    This principle states that assets should be recorded at the amount paid to acquire them. Depreciation can be recorded as well but separately. This policy is also referred to as the historical cost principle.

    3. Matching Principle

    This principle states that expenses should be matched with the revenues they helped generate. In general, cost and revenue should be recognized on any sold products during that period of time.

    4. Full Disclosure Principle

    This principle dictates that firms must disclose all information relevant to their financial statements. This includes both positive and negative information. This allows investors and other interested parties to make an informed decision about the company.

    5. Objectivity Principle

    This principle requires that financial statements be prepared objectively and without bias. This means that there should be no personal opinions or judgments included in the financial reporting process.

    What Factors Influence Which Accounting Policies Are Chosen?

    There are a few different factors that may influence which accounting policies a business chooses to adopt:

    1. The Business’ Industry

    Certain industries have more stringent accounting policies than others. For example, the banking and insurance industries are typically more regulated and have to follow stricter guidelines.

    2. Location

    Businesses in different countries may be required to adhere to different accounting policies. For example, businesses in the United States must follow GAAP. Businesses in the United Kingdom, on the other hand, typically follow IFRS.

    3. Size of the Business

    The size of a company can also play a role in which accounting policies are chosen. Larger businesses are typically more regulated. They also require a more thorough level of detail to maintain good organization.

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    Conservative vs Aggressive Policies

    Businesses may also choose to adopt conservative or aggressive methods of accounting. A conservative policy means that the company is more likely to adhere to the accounting rules set out by GAAP or IFRS. An aggressive policy means that the company is willing to break these rules in order to improve its financial performance.

    Each option has its pros and cons. A conservative policy may make a company appear more reliable to outsiders. It can also limit a company’s ability to grow and expand. An aggressive policy, on the other hand, can lead to greater profits but also comes with more risk.

    Do Small Businesses Need Accounting Policies?

    Small businesses do not necessarily need to adopt aggressive accounting policies. However, it is still a good idea for them to have some basic guidelines in place. This will help ensure that financial information is consistently reported. It also ensures that all transactions are accurately recorded.

    One of the most important aspects of running a small business is maintaining accurate financial records. Having accounting policies in place will make this process much easier.

    Working with a CPA or bookkeeper can also be helpful. They can help you develop policies that are specific to your business. When tax time comes around, your business will be in a much better position to file its returns.

    The Significance of Accounting Policies

    Accounting policies are needed. They set out the rules by which a company reports its financial information.

    1. Government retaining a hold on financial statements

    One example of the importance of accounting policies is when the government retains a hold on a company’s financial statements. In this case, the government is essentially saying that it does not trust the company’s numbers. This can be very damaging to a company’s reputation and may even lead to its downfall.

    2. Proper framework

    Conservative accounting policies also provide a framework within which financial statements can be accurately prepared. This ensures that all financial information is reported in a consistent manner. This makes it easier for investors and other interested parties to compare. It makes analyzing a company’s financial performance possible.

    3. Providing advantage to investors

    Corporate accounting policies can also provide investors with a valuable advantage. Understanding a company’s accounting events is helpful for investing. Investors can better understand how the company is performing financially. This information can help investors make more informed investment decisions.

    Summary

    Your choice in accounting policies is important for businesses of all sizes. They set out the rules by which a company reports its financial information. Businesses do not need complicated accounting practices to be effective. Good accounting frameworks help to prepare accurate financial statements. This makes it easier for investors to compare and analyze a company’s financial performance.

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    FAQs on Accounting Policies

    Are accounting policies mandatory?

    No, accounting policies are not mandatory. However, most businesses choose to adopt them in order to ensure that their financial statements are prepared in accordance with GAAP or IFRS.

    Can accounting policies be changed?

    Yes, accounting policies can be changed. However, any changes must be made in accordance with GAAP or IFRS.

    Are there new accounting policies?

    Yes, new accounting policies are released all the time. However, the most common ones are GAAP and IFRS.

    Can I get a copy of a company's accounting policies?

    Yes, you can often find a company’s accounting policies on its website. You may also be able to obtain a copy from the company’s investor relations department.

    Do accounting policies always have to be followed?

    No, accounting policies do not have to be followed. However, businesses that do not follow them may be subject to penalties from the government.

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