Accounting Policies

Accounting policies are the specific principles, bases, conventions and methods a company selects and consistently applies when preparing and presenting its financial statements. Broad accounting standards, whether US GAAP or IFRS, frequently allow a choice between acceptable methods for the same type of transaction, and a company's accounting policies are the concrete decisions it makes within those permitted choices, applied the same way period after period.

Accounting policies span decisions such as which inventory valuation method to use, how to recognise revenue across different types of contracts, which depreciation method and useful lives to apply to fixed assets, how to classify leases, and when to recognise a provision for a future liability. None of these choices is inherently more “correct” than the alternatives permitted by the relevant standard; what matters is that the company picks a defensible method for each and applies it consistently, so that its financial statements are comparable from one period to the next.

Companies are required to disclose their significant accounting policies in the notes to their financial statements, typically in the very first note, precisely because the same underlying transaction can produce different reported figures depending on which policy a company has chosen. An investor or lender reading one company's audited financials needs to know, for example, whether inventory is valued using first-in-first-out or weighted average cost, since comparing two companies without accounting for that difference can lead to the wrong conclusion about which one is actually performing better.

Where more than one method is permitted, management chooses the policy it judges best reflects the economic substance of its transactions, within the boundaries set by the applicable accounting standard, and that choice is then reviewed by the company's auditors as part of the annual audit. The chosen policies are expected to be applied consistently across reporting periods, which is why a change part way through a company's history is treated as significant and disclosed clearly, rather than simply absorbed silently into the next set of results.

A company can change an accounting policy, but only when the change is required by a new accounting standard or when it results in financial statements that more fairly present the company's transactions, never simply to produce a more favourable-looking result in a given period. When a genuine policy change does occur, accounting rules generally require the company to restate prior-period figures as if the new policy had always been in use, so that trends across periods remain comparable rather than being distorted by the switch itself.

Accounting policies are often confused with accounting estimates, but the two are treated quite differently under both US GAAP and IFRS. A policy is the method chosen — straight-line versus accelerated depreciation, for instance — while an estimate is a judgment made in applying that method, such as how many years an asset's useful life is expected to run, or how large an allowance for doubtful receivables should be. Changing an estimate as new information comes in, say extending a machine's useful life after it turns out to be more durable than first assumed, is routine and handled prospectively, affecting only current and future periods. Changing the underlying policy itself, by contrast, is the more significant event that generally triggers restatement of prior periods, which is why auditors and regulators draw a sharp line between the two even though, to someone outside accounting, both can look like simply a shift in a number on the financial statements. A company that quietly shortens an asset's useful life, for instance, is adjusting an estimate, while one that switches its entire inventory valuation method from weighted average to first-in-first-out is changing a policy, and the difference in required disclosure between the two is deliberately significant. Investors reading a company's annual report are specifically directed to the notes section covering changes in accounting policy, since a quiet change there can meaningfully shift reported results without any change at all in the company's actual underlying business.