Accounting Policies: Definition, Use, and Examples

Key takeaways

• Accounting policies are the procedures and methods management uses to prepare financial statements.
• Policies implement accounting principles (GAAP or IFRS) but allow management discretion where rules are flexible.
• Choices in accounting policies can legitimately affect reported earnings and indicate whether management is conservative or aggressive.
• Investors and auditors should review a company’s accounting policy disclosures to assess the quality of earnings.

What are accounting policies?

Accounting policies are the specific methods, measurement bases, and disclosure practices a company applies when preparing its financial statements. They translate accounting principles and standards (such as GAAP or IFRS) into the company’s day-to-day reporting rules—for example, how depreciation is calculated or how inventory is valued.

How accounting policies are used

Accounting policies govern treatment of complex or judgmental items, including:
* Depreciation and amortization methods
* Inventory valuation methods
* Recognition and measurement of goodwill and impairments
* Capitalization versus expense of research and development costs
* Valuation of investments and fixed assets
* Foreign currency translation and hedge accounting
These policies must conform to the applicable accounting framework (e.g., GAAP or IFRS), but where standards allow choices, management selects the policy that best reflects its circumstances—or that produces the financial presentation it prefers.

Example: inventory valuation (FIFO, LIFO, average cost)

Inventory valuation methods are a common area where policy choice affects reported profit.

Scenario:
* Purchases: 10 units at $10, 10 units at $12 (total 20 units)
* Units sold during the period: 15

Calculations:
* FIFO (first in, first out): COGS = (10 × $10) + (5 × $12) = $160
* Average cost: weighted average unit cost = ($100 + $120) / 20 = $11 → COGS = 15 × $11 = $165
* LIFO (last in, first out): COGS = (10 × $12) + (5 × $10) = $170

When inventory prices are rising:
* FIFO yields lower COGS and higher reported profit.
* LIFO yields higher COGS and lower reported profit (and lower taxable income under some tax regimes).

Note: U.S. GAAP permits LIFO; IFRS does not.

Accounting policies vs. accounting principles

• Accounting principles are the standardized rules and objectives set by standard setters (e.g., FASB, IASB).
• Accounting policies are the specific choices and procedures management adopts to comply with those principles. Principles set the framework; policies operationalize it.

Conservative vs. aggressive accounting

• Conservative policies tend to understate assets or income (higher expenses, earlier expense recognition), which may produce lower earnings in the short term but fewer surprises later.
• Aggressive policies tend to overstate assets or income (lower expenses, delayed expense recognition), which can boost short-term reported performance but may create future reversals or increased risk.
  The chosen stance affects investor perception, credit assessments, and trend comparability.

Implications for stakeholders

• Investors: Review the notes to the financial statements to understand policies and how they affect comparability and earnings quality.
• Analysts: Adjust or normalize financials when different policy choices materially affect performance comparisons across firms.
• Auditors and regulators: Ensure policies comply with applicable standards and are applied consistently and transparently.
• Management: Should select and disclose policies that faithfully represent the company’s financial position and performance.

Best practices

• Disclose material accounting policies clearly in the financial statement notes.
• Apply policies consistently from period to period; disclose and justify any changes.
• Provide quantitative sensitivity or reconciliation where policy choices materially affect results.
• For users of financial statements, check policy disclosures before drawing conclusions from reported figures.

Conclusion

Accounting policies are the practical choices companies make to apply accounting standards. They play a major role in how financial performance and position are presented. Understanding and reviewing these policies—especially in areas that require judgment—helps stakeholders assess the reliability and comparability of reported financial information.