Accounting Policies: Concept and Benefits

Every economic entity has its own approach to preparing its financial statements, determined by its strategies, objectives, nature of operations, and the market in which it competes. This approach helps the entity make informed and well-considered decisions. 

In this article, we shed light on everything related to what is known as accounting policies and how they affect different economic institutions.  

What Are Accounting Policies?

Accounting policies are defined as a set of written guiding rules adopted by an organization to ensure the proper preparation of its financial reports. 

These policies establish a group of rules and auditing standards aimed at measuring the company’s financial position. 

Accounting policies may be conservative or aggressive, and each type has its own method based on how the organization handles the preparation of financial reports, something we will explain in the following lines. 

These policies follow either the International Financial Reporting Standards (IFRS) or the Generally Accepted Accounting Principles (GAAP). Regardless of the type of policy a company prefers, the financial team must fully understand and adhere to the specific guidelines to ensure accurate measurement and fair representation of financial data. 

Examples of accounting policies include:
 

• Inventory valuation, such as choosing between First-In, First-Out (FIFO), Last-In, First-Out (LIFO), or the weighted average method.
   
• Selecting a depreciation method, such as the straight-line method, declining balance method, or units-of-production method.
   
• Determining the appropriate timing and criteria for revenue recognition, especially for companies operating in industries with complex transactions.
   
• Choosing the standards applied by the financial management when estimating and recording bad debts.

The Importance of Accounting Policies

Accounting policies play a vital role in the economic activities of any organization, not only internally, but also for investors and governments. Below, we highlight some aspects of the importance of accounting policies for various stakeholders.  

1- Comprehensive Government Oversight

All companies must define their accounting policy according to one of the systems mentioned in this article, whether GAAP or IFRS. This allows governments to stay continuously informed about everything related to the financial performance of companies, enabling them to protect the interests of investors in the country. 

2- Maintaining a Unified Framework 

Defining an accounting policy helps each company follow a unified format when preparing various types of financial statements. This ensures consistency in all outputs of the company’s financial department and helps improve the organization of its financial management. 

3- Enhancing Investor Confidence 

When investors find that a company adheres to a single policy in its accounting operations, they feel more confident in dealing with it. This also helps them compare the company’s financial data across different time periods or with other competing companies easily, enabling them to make the right investment decisions. 

4- Reducing Errors and Risks 

Relying on unified accounting policies within a company helps increase the accuracy of financial reports by establishing consistent procedures for recording all types of financial transactions. This reduces the chances of accounting errors or inconsistencies between accounting books, especially in large and complex financial transactions where the risk of oversight or mistakes increases in ways that could affect final results. 

5- Facilitating Compliance with Regulations 

The presence of accounting policies helps various organizations comply correctly with the regulations and rules set by regulatory bodies in each country, protecting them from the penalties and fines that may result from violating the standards established for companies operating within their borders.   

6- Clearly Defining Employee Roles 

Accounting policies play an important role in providing clear guidance on how to record the company’s financial transactions and the optimal method for disclosing them. This helps employees, especially new hires, understand their roles and responsibilities, and contributes to preparing them properly to help make the company’s financial management more organized, ultimately supporting the overall financial health of the organization.  

How to Apply Accounting Policies in Companies?

There are many financial statements in companies that are calculated using specific methods or formulas, and there may be more than one acceptable method for the same financial statement. 

In such cases, the company’s financial management should choose one method based on the accounting policy it follows. 

In any case, these accounting formulas must comply with GAAP or IFRS standards, depending on what the company adopts. When evaluating any company and reviewing its financial statements, it is important to consider its accounting principles. 

The financial report provided by the company may have been prepared using an aggressive accounting policy, while another company that reports moderate financial gains may follow a conservative accounting policy. Therefore, before making any decision or reading the financial statements of any company, investors should accurately understand the accounting policy followed by the company.  

Examples of Accounting Policies

The results of a company’s profit can vary depending on the accounting policy it adopts, whether aggressive or conservative. Below is a practical example of accounting policies used by companies in inventory valuation. Companies may rely on the First-In, First-Out (FIFO) method, Last-In, First-Out (LIFO) method, or the weighted average method. 

If a company uses the FIFO method, it records the cost of the inventory purchased first when selling goods. If it uses the LIFO method, the cost of the most recently purchased inventory is considered the cost of goods sold. I

f the company uses the weighted average method, the cost of all available inventory is averaged to calculate the cost of goods sold. 

When market prices rise, the FIFO method is better because it lowers the cost of goods sold and increases profits. Therefore, in this case, FIFO can be considered more aggressive than LIFO.   

For example: If a person owns a shoe factory and the retail price of a shoe is $50, and in the last month, the factory produced 100 shoes at a cost of $10 per shoe during the first 15 days, and another 100 shoes at $20 per shoe during the last 15 days of the month. At the end, the person sold 30 shoes. 

The total sales would be: 50 × 30 shoes = $1,500. 

But how is the cost of goods sold calculated? If the company uses FIFO, the cost of goods sold would be: $10 × 30 shoes = $300, resulting in a net income of $1,200.   

You can easily calculate the cost of goods sold using Daftra’s ready-made model for calculating the cost of goods sold. 

If the company uses LIFO, the cost of goods sold would be: $20 × 30 shoes = $600, resulting in a net income of $900. 

If the weighted average method is used, the cost would be: ($20 + $10) / 2 × 30 shoes = $450, resulting in a net income of approximately $1,050. 

The Daftra accounting software supports all three methods by allowing users to set the method in inventory settings and record cost data for each batch, in addition to providing periodic and detailed reports.  

The Difference Between Accounting Policies and Accounting Principles

Many people confuse the concepts of accounting principles and accounting policies and do not know the difference between them. However, there is a fundamental distinction between the two that financial management staff in organizations must be aware of in order to perform their duties effectively. 

As we explained the concept of accounting policies at the beginning of this article, it is also important to clarify the meaning of accounting principles in a simple way. Accounting principles are the guiding rules, frameworks, and fundamental standards that govern the field of accounting. 

These principles form the theoretical foundation upon which accounting practices and standards are built. They are a set of generally agreed-upon principles by accounting professionals to ensure consistency, reliability, and ease of comparison between different financial statements. 

These principles are usually documented in the form of internationally recognized systems such as the International Financial Reporting Standards (IFRS) and the Generally Accepted Accounting Principles (GAAP). Some examples of these principles include:

• Historical Cost Principle: Recording assets at their original purchase price.
   
• Revenue Recognition Principle: Recognizing revenue when it is verifiable or earned by the organization.
   
• Matching Principle: Expenses should correspond to the revenues they help generate.
   
• Full Disclosure Principle: Financial statements must disclose all necessary information to users to help them make informed decisions.
   
• Conservatism Principle: When choosing between two options, the one that does not overestimate assets or income should be selected.

Key Differences Between the Two Concepts

After explaining what accounting principles are and what accounting policies are, it is important to highlight the main differences between them, summarized briefly as follows: 
 

Concept: 

Principles are broad, fundamental concepts intended to guide overall accounting practices, whereas policies are specific, detailed rules and procedures developed by companies to apply principles in practice. 
 

Policy and Scope: 

Principles are universal and consistent across various sectors and countries that implement them. Policies, on the other hand, are specific to each company and tailored to its operations and strategic choices. 
 

Authority: 

There is also a difference in authority between principles and policies, depending on the body that establishes them. Principles are set by the International Accounting Standards Board (IASB) or the Financial Accounting Standards Board (FASB), while policies are determined by a company’s financial management based on the general accounting principles it follows. 
 

Flexibility and Adaptation: 

Accounting policies are more flexible and adaptable to the current situation and the company’s needs compared to accounting principles, which tend to be more rigid.  

Frequently Asked Questions

How many accounting policies exist?

Each organization defines its general accounting policies according to the accounting principles it follows. In general, accounting policies can be divided into two types: aggressive or conservative.   
 

What is the accounting policy for inventory? 

Inventory accounting policies may follow First-In, First-Out (FIFO), Last-In, First-Out (LIFO), or the weighted average method.  
 

Is depreciation an accounting policy? 

Yes, depreciation is an accounting policy that specifies how to allocate the cost of tangible assets, such as machinery, vehicles, and others, over their useful lives to calculate the amount consumed during a specific period using clear and precise methods.   
 

What are a company’s accounting policies? 

They are the principles and methods a company establishes to create its own financial and accounting system, providing a complete and accurate picture of its financial and accounting position.  
 

What is the difference between accounting policies and accounting estimates?

• Accounting Policies: Fixed rules established to organize and present the company’s financial and accounting operations.
• Accounting Estimates: Numbers or amounts determined when precise figures are not available, used as a basis for certain values such as asset life, costs, and other metrics.
   

In conclusion, this article covered the most important concepts and information related to defining accounting policies for companies and distinguishing them from accounting principles, illustrated with examples to make understanding easier. If you found this topic useful, share it with colleagues interested in business and accounting management. You can also rely on Daftra accounting software to help implement the appropriate accounting policy for your business project.