What it means
Accounting standards such as IFRS and US GAAP set the rules, but they leave room for judgement. Should inventory be valued on a first-in, first-out basis or a weighted average?
Should a building be depreciated over 25 years or 40? When exactly does revenue from a two-year service contract count as earned?
Each of these choices is an accounting policy, and different but equally legitimate choices can produce very different profit figures for the same underlying business. That is why the accounting policies note matters so much to anyone reading financial statements.
It is usually the first or second note in the annual report and it tells you the basis on which every number was prepared. A careful reader checks it before comparing two companies.
If one retailer uses FIFO and its rival uses weighted average during a period of rising prices, their gross margins are not directly comparable until you adjust for the difference. Once chosen, a policy must be applied consistently.
A company cannot switch depreciation methods simply because a different one would make this year's profit look better. Changes are permitted only when a new standard requires it or when the change produces more reliable and relevant information, and in either case the change must be disclosed, explained and, in most cases, applied to prior years as well so that the comparatives are restated.
Accounting estimates, such as the useful life of a machine, are different from policies: revising an estimate is applied going forward and is not a change of policy. Auditors pay close attention to policies because they are where management has the most discretion.
Aggressive policies (recognising revenue early, capitalising costs that others would expense, long depreciation lives) flatter profit now at the expense of later years. Conservative policies do the reverse.
Neither is illegal, but the reader needs to know which way the company leans.
In practice
Real-world examples.
Example
A construction company's revenue recognition policy states that it recognises revenue on long contracts by the percentage of work completed, measured by costs incurred to date as a proportion of total expected costs.
Example
A software business's policy on development costs states that research spending is expensed as incurred while development spending is capitalised once technical and commercial feasibility are demonstrated.
Example
An airline's policy on aircraft depreciation states that airframes are depreciated on a straight-line basis over 20 years to a residual value of 10% of cost, with engines and major overhauls treated as separate components.
Think of it
“Accounting policies are the specific rules a company chooses for how to record and report financial information.
Formula
Calculation
Accounting policies are not calculated, but their effect can be. Here is the same business under two inventory policies during a year of rising purchase prices.
A shop buys 100 units in January at $10 each and 100 units in June at $14 each, and sells 150 units during the year for $20 each.
- Revenue: 150 x $20 = $3,000
Under FIFO (first-in, first-out): the 150 sold are the 100 January units plus 50 June units.
- Cost of goods sold = (100 x $10) + (50 x $14) = $1,700
- Gross profit = $3,000 minus $1,700 = $1,300
- Closing inventory = 50 x $14 = $700
Under weighted average: average cost = (100 x $10 + 100 x $14) / 200 = $12
- Cost of goods sold = 150 x $12 = $1,800
- Gross profit = $3,000 minus $1,800 = $1,200
- Closing inventory = 50 x $12 = $600
Same shop, same sales, same cash, but $100 more profit under FIFO. Over many years the difference washes out, but in any single year the policy choice moves the reported result.Case study
Seen in the real world.
Two listed logistics companies of similar size reported operating margins of 9% and 6%. An analyst comparing them read the accounting policies notes and found the difference was largely policy, not performance. The first company capitalised the cost of fitting out leased warehouses and depreciated it over 15 years; the second expensed fit-out costs as incurred.
The first depreciated its truck fleet over 12 years; the second over 8. After adjusting the first company's accounts to the second's policies, its operating margin fell to about 6.5%.
The analyst's report concluded that the two businesses were performing almost identically, but that the first company's reported profits would fall relative to its rival in coming years as the deferred costs caught up with it. Its share price had been trading at a premium that the underlying business did not justify.
Watch out
Common mistakes.
- Comparing profit figures across companies without checking that their policies are comparable, especially for inventory, depreciation, revenue recognition and capitalised costs.
- Confusing a change in accounting estimate (a revised useful life) with a change in accounting policy (a switch from straight-line to reducing-balance depreciation). They are treated differently.
- Treating the accounting policies note as boilerplate. It is where the discretion lives.
Questions
People also ask.
Can a company choose any policy it likes?
No. The policy must be permitted by the applicable standards and must be applied consistently, and the choice must produce information that is relevant and reliable.
Where do I find a company's accounting policies?
In the notes to the financial statements, usually titled "Summary of significant accounting policies" or "Basis of preparation".
Why would a company change an accounting policy?
Usually because a new standard requires it, or because the new policy gives a fairer picture. Any change must be disclosed with its effect on prior years.
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