how accounting policies are used
accounting policies are a set of standards that govern how a company prepares its financial statements these policies are used to deal specifically with complicated accounting practices such as depreciation methods recognition of goodwill preparation of research and development r d costs inventory valuation and the consolidation of financial accounts these policies may differ from company to company but all accounting policies are required to conform to generally accepted accounting principles gaap and or international financial reporting standards ifrs 12accounting principles can be thought of as a framework in which a company is expected to operate however the framework is somewhat flexible and a company s management team can choose specific accounting policies that are advantageous to the financial reporting of the company because accounting principles are lenient at times the specific policies of a company are very important looking into a company s accounting policies can signal whether management is conservative or aggressive when reporting earnings this should be taken into account by investors when reviewing earnings reports to assess the quality of earnings also external auditors who are hired to review a company s financial statements should review the company s policies to ensure they conform to gaap company management can select accounting policies that are advantageous to their own financial reporting such as selecting a particular inventory valuation method example of an accounting policyaccounting policies can be used to legally manipulate earnings for example in the united states companies are allowed to value inventory using the average cost first in first out fifo or last in first out lifo methods of accounting under the average cost method when a company sells a product the weighted average cost of all inventory produced or acquired in the accounting period is used to determine the cost of goods sold cogs under the fifo inventory cost method when a company sells a product the cost of the inventory produced or acquired first is considered to be sold first under the lifo method when a product is sold the cost of the inventory produced last is considered to be sold first in periods of rising inventory prices a company can use these accounting policies to increase or decrease its earnings for example a company in the manufacturing industry buys inventory at 10 per unit for the first half of the month and 12 per unit for the second half of the month the company ends up purchasing a total of 10 units at 10 and 10 units at 12 and sells a total of 15 units for the entire month if the company uses fifo its cost of goods sold is 10 x 10 5 x 12 160 if it uses average cost its cost of goods sold is 15 x 11 165 if it uses lifo its cost of goods sold is 10 x 12 5 x 10 170 in the us where companies are able to choose between fifo and lifo a company wishing to maximize profits will use the fifo method in periods of rising prices in order to minimize the cost of goods sold and increase earnings a company wishing to lower taxable income will use the lifo method if prices are rising to increase the cost of goods sold and decrease earnings 