What Is an Accounting Policy and What Should It Include?

An accounting policy represents the specific principles and procedures a company uses to prepare its financial statements. These policies are the rules that govern how a business records and reports its financial activities. The purpose of these policies is to ensure financial information is prepared consistently from one period to the next. This consistency allows investors, regulators, and management to compare financial results over time and against other companies, providing a clear picture of a company’s financial health.

Guiding Frameworks for Policy Selection

A company’s accounting policies are governed by established frameworks. In the United States, businesses follow the Generally Accepted Accounting Principles (GAAP), a rules-based system set by the Financial Accounting Standards Board (FASB). For companies in many other parts of the world, the framework is the International Financial Reporting Standards (IFRS), which is more principles-based and developed by the International Accounting Standards Board (IASB). While GAAP provides specific rules, IFRS offers broader principles, allowing for more judgment in its application.

Within these frameworks, the materiality principle dictates that information that could influence an investor’s decision must be reported, helping companies focus on significant transactions. Another guiding principle is neutrality, which requires that financial information be presented without bias.

Key Areas Covered by Accounting Policies

Accounting policies cover many aspects of a company’s finances, with some areas having a significant impact on financial statements. The choices made can influence reported profits and the valuation of a company’s assets. One area is revenue recognition, which defines when a company can record income. The policy specifies the conditions under which revenue is earned, such as at the point of sale for a retail company or upon completion of a service for a service-based business. For long-term projects, a company might use a percentage-of-completion method, recognizing revenue in stages.

Inventory valuation is another policy area for companies that buy and sell goods. Because inventory costs can fluctuate, a company must choose a method to determine the cost of goods sold and the value of remaining inventory. Common methods in the U.S. include First-In, First-Out (FIFO), which assumes the first items purchased are the first sold, and Last-In, First-Out (LIFO), which assumes the most recent items are sold first. LIFO is not permitted under IFRS. A third choice is the weighted-average cost method.

The treatment of fixed assets and depreciation is also governed by policy. When a company purchases a long-term asset like a building or vehicle, it cannot expense the entire cost at once. Instead, the cost is allocated over its useful life through depreciation. The straight-line method allocates an equal amount of depreciation to each period, while other methods include the declining balance method and the units-of-production method.

Creating the Accounting Policy Manual

An accounting policy manual is the formal documentation of a company’s policies, serving as a guide for finance and accounting teams. This manual is an internal control tool that translates high-level principles from frameworks like GAAP into specific procedures. It also acts as a training resource for new employees and a reference for existing staff, helping to minimize errors.

Developing the manual begins with identifying all business activities that require a formal policy, from customer returns to investments. The accounting team then researches acceptable treatment options under the relevant standards to ensure compliance. After research, each policy is drafted in clear, unambiguous terms, reviewed, and approved by senior management. The final step is implementation, which involves distributing the manual and providing training.

Policy Changes and Financial Statement Disclosure

Changes to accounting policies are discouraged unless specific circumstances warrant them. A company must change a policy if a new accounting standard is issued by a body like the FASB. A voluntary change is permissible only if it can be justified that the new policy provides more reliable and relevant financial information.

Communicating these policies to external parties is a requirement for transparency. This is done through a dedicated section in the footnotes of the financial statements, titled the “Summary of Significant Accounting Policies.” This is one of the first and most important footnotes, as it provides the context needed to understand how the statements were prepared and allows stakeholders to see the specific choices the company has made. The summary outlines the policies the company has adopted, such as the method used for revenue recognition, inventory valuation, and depreciation. It does not simply repeat the rules of GAAP but explains the specific application chosen by the company. This disclosure enables users to make more informed comparisons between different companies.