A Guide to Accounting Policies for Businesses

Accounting policies are the rules and methods that a company uses to prepare its financial statements. They guide how the company records, measures, and reports its financial activities.

Importance of Accounting Policies 

Accounting policies are not only essential for a company, but they are also useful for investors and regulatory bodies. Here’s how:

Based on the different types of company transactions, accounting policies can be categorized into the following categories:

Revenue Recognition Policies 

The revenue recognition policy helps a company decide when to record revenue. It can be at the time of sale, upon delivery, or gradually over time. It also defines whether revenue is measured in gross or net terms. Companies generally follow one of these three methods:

• Accrual Basis: This is when the revenue is recorded when it is earned, even if the payment is received later. This method helps match revenue with related expenses.
• Cash Basis: In this method, the revenue is recognized when the payment is received. It is a simpler method and is often used by small businesses.
• Installment Sales Method: The revenue, in this process, is registered as the payments are received over time, usually when the goods or services are delivered over an extended period.

Expense Recognition Policies 

Expense recognition policies are the guidelines a company follows to determine when and how expenses are recorded in the financial statements. These policies typically align expenses with the revenues they help generate, ensuring accurate financial reporting.

• Matching Principles: Under Generally Accepted Accounting Principles (GAAP), the matching principle serves as the foundation for expense recognition. It requires that expenses be recorded in the same accounting period as the revenues they contribute to, providing a clearer picture of financial performance.
• Depreciation and amortization methods: This method is used for depreciation and amortization, depending on the type of asset, the applicable reporting rules, and the organization’s financial goals. These methods impact the financial statements by altering how expenses are allocated over time and how asset values are presented.

Inventory Valuation Policies 

Inventory valuation policies are used to determine the method of measuring inventory in financial statements. Their primary goal is to accurately represent a company’s gross profit. These policies affect both the cost of goods sold (COGS) and the value of unsold inventory, which in turn affects the company’s overall profitability. When valuing inventory, your business can choose from several methods:

• First-In, First-Out (FIFO): FIFO assumes the oldest inventory is sold first. The remaining stock is valued at the most recent costs. It’s simple to use, but it may not reflect true costs if prices change quickly.
• Last-In, First-Out (LIFO): LIFO is based on the principle that the newest inventory is sold first, and older items stay in stock. This method may lead to losses over time if older inventory becomes outdated or unsellable.
• Weighted Average Cost: This method calculates the cost of goods sold and ending inventory by using the average cost of all units.. It’s useful when an individual item cost can’t be tracked, such as with identical or bulk items.

Choosing the right accounting policies depends on the nature of the business, regulatory environment, and financial goals. When applied correctly, these policies provide a better view of a company’s financial health—helping decision-makers and investors evaluate performance, manage risk, and plan for future growth.