Accounting policies represent internal business standards that employees follow when recording financial transactions. Business owners and directors use accounting to record, report and analyze financial transactions. While financial transactions must be recorded according to generally accepted accounting principles (GAAP), business owners have some latitude when developing accounting policies. GAAP is a principles-based framework, rather than rules-based, which requires business owners to use accounting policies when recording certain financial transactions.
Depreciation is a monthly expense relating to business assets. Companies purchase facilities and equipment to produce goods or services. Rather than expense these items at one time, GAAP allows companies to record the purchase as an asset, and depreciate the item over time. Business owners can use several different depreciation methods for their accounting policy. Straight line, declining balance and activity depreciation are a few commonly used methods. Depreciation methods depend on the type of asset, salvage value and expected useful life.
Inventory valuation is another important accounting policy. Commonly used valuation methods include first-in, first-out (FIFO); last-in, first-out (LIFO); and weighted average. FIFO requires companies to sell the oldest inventory first. This method ensures the company has the newest inventory and most accurate information in the company’s accounting ledger. LIFO, the opposite of FIFO, is where companies sell the newest inventory first, leaving the older inventory in the ledger.
The weighted average method simply recalculates a new cost for inventory items. This method does not require companies to maintain a record of which inventory sells first. Business owners set accounting policies for inventory because this information directly impact the company’s tax liability at year end.
Larger businesses use accounting policies to consolidate financial accounts. Business organizations maintaining ownership stakes in other companies may need to consolidate financial accounts. Consolidating financial accounts creates one set of financial information for the parent and subsidiary companies. Asset, liability, revenue, costs of goods sold and retained earnings are a few financial accounts that may require consolidation per accounting policies.
Research and development costs usually require accounting policies. Development costs can carry forward on a company’s accounting ledger, which creates a capitalized expense. Companies may not recognize capitalized research and development expenses until the new product, facilities or equipment goes into use in business operations. However, companies usually expense basic research and development costs as they occur. Basic research costs indirectly affect the research and development costs. Business owners set accounting policies to determine which research and development items can carry forward and which are written off.