What it means
Accounting standards set the framework, but they leave real room for judgement. A company must decide how to value its inventory, how fast to depreciate its equipment and when to record revenue on complex contracts.
The collection of those decisions is its set of accounting policies. Policies matter because they change the numbers without changing the underlying business.
A company that depreciates a machine over 10 years reports higher profit in the early years than one that depreciates the same machine over 5 years. Neither is wrong, but readers need to know which was used, because the choice can move reported profit by a large amount over the life of the asset.
Companies must disclose their significant policies in the notes to the financial statements. This lets investors, lenders and analysts compare one business with another on a like-for-like basis.
When a company changes a policy, it normally has to explain why and, in most cases, restate prior periods so the comparison stays fair. A good policy is applied consistently and reflects the economic reality of the business.
Management should not switch methods to flatter a bad quarter, and auditors look closely for exactly that behaviour. Policy choices that are aggressive, such as recognising revenue early, are a classic warning sign.
Within a business, policies also work as a manual for staff. They state, for example, that expenses above a set amount must be capitalised (recorded as an asset instead of an expense) or that customer credit terms are 30 days.
Written policies reduce disputes and make onboarding new accountants far easier. Policies also interact with tax.
Some choices affect taxable profit as well as reported profit, while others are accepted for the accounts but ignored by the tax authority, so a company may keep two sets of calculations. Finance teams document these differences so that nobody is surprised when the tax bill does not match the profit shown in the accounts.
In practice
Real-world examples
Example 1
A manufacturer chooses to value its inventory using the first-in, first-out method, which assumes the oldest stock is sold first. Its policy note says so, which tells investors why cost of goods sold looks lower when input prices are rising.
Example 2
A software firm sets a policy that it will capitalise (treat as an asset) development costs only after a product reaches technical feasibility. Earlier spending is expensed immediately. This policy keeps its reported profits more conservative, although it also means the company reports lower profit in years when it is investing heavily in new products.
Example 3
A small charity writes a policy that any purchase above $2,500 with a life of more than one year is recorded as equipment and depreciated. Smaller purchases are expensed straight away. The treasurer uses this rule to keep the books consistent from year to year, and new volunteers can follow it without needing specialist training.
Think of it
Accounting policies are the specific rules a company chooses for how to record and report financial information.
Case study
Seen in the real world
Cobalt Ridge Logistics is a fictional freight company that, in this illustrative story, bought a fleet of trucks for $2,400,000. Its first-year policy depreciated the trucks over 8 years, giving annual depreciation of $300,000.
After a tough year, a manager suggested stretching the life to 12 years, which would cut annual depreciation to $200,000 and lift profit by $100,000. The finance director refused, explaining that the trucks were not actually lasting longer and that the change would look like manipulation to the auditors and the bank.
Instead the company kept the original policy and disclosed it clearly in the notes. When the lender later reviewed the accounts, the consistent policy gave it confidence that the reported profit was genuine, and the loan renewal went through without extra conditions, and the finance director later used the episode to train new staff on why consistency matters.
Watch out
Common mistakes
- Believing that accounting policies are the same as accounting standards. Standards are the external rulebook, whereas policies are the choices the company makes within it. Confusing the two leads people to think a choice is compulsory when it is really a judgement.
- Changing a policy to improve a poor result. Changes should only be made when they give a more faithful picture, and they must be disclosed.
- Ignoring policies when comparing two companies. Different depreciation or revenue methods can make similar businesses look very different.
Questions
People also ask
Where can I find a company's accounting policies?
They are listed in the notes to the financial statements, usually near the front of the notes under a heading such as significant accounting policies.
Can a company change its accounting policy?
Yes, if the standards require it or if the new policy gives more reliable and relevant information. The change normally has to be explained and applied to comparative figures as well.
Do small private businesses need written policies?
They are not always legally required to publish them, but written policies are good practice and take only an afternoon to draft. They keep bookkeeping consistent and help when a lender or buyer asks questions.
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