What Is the Summary of Significant Accounting Policies?

The summary of significant accounting policies is a section within the footnotes of a company’s financial statements that details the specific accounting principles and methods the company has chosen to employ. This disclosure explains the “how” behind the numbers on the balance sheet and income statement. It provides transparency, allowing readers to understand the basis on which the financial figures have been prepared.

This summary is necessary because accounting standards often permit multiple ways to account for the same type of transaction. A company must select the methods that it believes most accurately reflect its economic reality. Outlining these choices provides a roadmap that helps investors, creditors, and other stakeholders understand the judgments and estimates inherent in the financial reporting process, which is needed for making informed decisions.

The policies disclosed can cover a wide range of financial activities, from how a company accounts for its buildings to when it records revenue from a sale. These choices can significantly influence a company’s reported financial performance and position. Understanding these policies allows for a more meaningful comparison between different companies and provides a basis for assessing the quality of a company’s earnings.

Mandatory Disclosures and Placement

The requirement for a summary of significant accounting policies is rooted in U.S. Generally Accepted Accounting Principles (GAAP). The Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 235 mandates this disclosure to ensure financial statements are transparent. The standard stipulates that a description of all significant accounting policies must be included as an integral part of the financial statements.

Companies are required to reveal the accounting principles and methods chosen from acceptable alternatives. This includes policies related to the valuation of major assets, the recognition of profits on long-term contracts, and the methods used to amortize intangible assets. The standard also requires disclosure of principles and methods that are peculiar to the industry in which the company operates.

The summary of significant accounting policies is almost always the first footnote presented after the main financial statements. This placement allows users to establish a baseline understanding of the company’s accounting practices before delving into more specific details about its financial condition and performance.

Key Policies Found in the Summary

Basis of Presentation/Consolidation

The basis of presentation and consolidation policy explains which entities are included in the financial reports. U.S. GAAP uses a two-model approach for this determination. The first is the voting interest model, where consolidation is required when a company owns more than 50% of another entity. The second is the Variable Interest Entity (VIE) model, where consolidation is based on which entity has a controlling financial interest, regardless of voting rights.

Consolidation means the parent company combines the assets, liabilities, revenues, and expenses of the subsidiary with its own, presenting them as a single economic entity. This policy also describes the accounting method used for business combinations, which is the acquisition method. It will also mention how investments in entities where the company has significant influence but not control (20% to 50% ownership) are accounted for, which is the equity method.

Use of Estimates

This policy acknowledges that preparing financial statements requires management to make estimates and assumptions. These estimates affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities. They also impact the reported amounts of revenues and expenses during the reporting period.

Common areas involving significant estimates include the allowance for doubtful accounts, the useful lives of property and equipment for depreciation purposes, and the fair value of financial instruments. This policy highlights that financial statements are based on management’s best judgment, and actual results could differ from those estimates.

Revenue Recognition

The revenue recognition policy details how and when a company records its revenue, guided by the principles in ASC 606. The core principle is that a company should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the expected payment.

This policy will describe the company’s process for:

• Identifying contracts with customers
• Identifying the performance obligations in the contract
• Determining the transaction price
• Allocating the transaction price to the performance obligations
• Recognizing revenue when the company satisfies a performance obligation

For example, a software company might recognize revenue over the term of a subscription, while a retail company recognizes revenue at the point of sale.

Cash and Cash Equivalents

This policy defines what the company considers to be cash and cash equivalents. Cash includes currency on hand and demand deposits with banks. Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and have an insignificant risk of changes in value. A company’s policy will state that only investments with original maturities of three months or less, such as commercial paper or treasury bills, qualify as cash equivalents.

Inventory Valuation

The inventory valuation policy explains how a company assigns costs to its inventory, which directly affects both the inventory value on the balance sheet and the cost of goods sold on the income statement. The policy will state that inventory is valued at the lower of cost or market. The focus of the policy is the method used to determine the cost of inventory.

Common costing methods include First-In, First-Out (FIFO), which assumes the first units purchased are the first ones sold, and Last-In, First-Out (LIFO), which assumes the last units purchased are the first ones sold. Another method is the weighted-average cost, which uses the average cost of all goods available for sale. The choice of method can significantly impact reported profits, especially during periods of changing prices.

Property, Plant, and Equipment (PP&E)

This policy outlines how a company accounts for its long-lived tangible assets, such as land, buildings, and equipment. PP&E is recorded at its historical cost, which includes the purchase price plus any costs necessary to prepare the asset for its intended use. The policy will also specify the company’s capitalization threshold, the minimum cost an item must have to be recorded as an asset rather than an expense.

The policy also details the method of depreciation, which is the process of allocating an asset’s cost over its useful life. The straight-line method allocates an equal amount of depreciation expense to each period. Some companies may use accelerated depreciation methods, which result in higher depreciation expense in the early years of an asset’s life. The policy will also disclose the estimated useful lives for different classes of assets.

Goodwill and Intangible Assets

This policy describes how a company accounts for assets that lack physical substance. Intangible assets with finite lives, such as patents, are amortized over their useful lives. Goodwill is an asset representing future economic benefits from other assets acquired in a business combination that are not individually identified.

For public companies, goodwill is not amortized but is tested for impairment at least annually. Private companies have the option to amortize goodwill over a period not to exceed ten years and test for impairment only when a triggering event occurs. If an impairment is identified, the company must write down the value of the goodwill, which results in a loss on the income statement.

Analyzing the Summary for Insights

By examining the policies a company has chosen, an analyst can gain insights into its financial health and management’s philosophy. A primary use of the summary is to assess comparability between companies in the same industry. For example, if one company uses the LIFO method for inventory and a competitor uses FIFO during a period of rising prices, their reported net incomes will differ. An analyst can use the summary to understand these differences and adjust for a more accurate comparison.

The summary is also where any changes in accounting policies from one year to the next are disclosed. A change in policy might be a one-time event that distorts the comparability of financial results over time. Understanding the nature and impact of these changes is needed for accurately assessing a company’s performance trajectory.

Finally, the choice of accounting policies can provide clues about whether a company’s accounting is more aggressive or conservative. A company that chooses longer depreciable lives for its assets compared to its industry peers may be viewed as having more aggressive accounting, as this results in lower depreciation expense and higher net income. These insights help an investor form a more complete picture of the company’s financial reporting quality.