Critical accounting policy

In public corporate finance, a critical accounting policy is a policy for a firm/company or an industry which is considered to have a notably high subjective element, and that has a material impact on the financial statements. These policies are often mandated to be described in detail in specific sections of a company's annual or quarterly reports.

Many accounting policies necessarily involve subjective valuations placed on different items in order to allow an observer to get the best possible "snapshot" of a company by looking at a single balance sheet or profit and loss statement. For example, a bank that has just made a lot of new loans would look good on one report, but if many of those borrowers later failed to pay then a subsequent report would look very bad. So generally accepted accounting principles (GAAP) would require the bank management (and not the accountants) to estimate how many borrowers would fail to pay and include those losses alongside the new loans. While there are many situations common to almost all companies where management must make subjective accounting entries, critical accounting policies often are those particular to an industry or company, and are judged to be even more subjective then normal.

One of the key reasons many investors and analysts pay attention to critical accounting policies, is that their subjective nature is believed to be more ripe for abuse by creative accounting, especially slush fund accounting. In slush fund accounting, excess earnings from a good quarter or year are hidden by changing the subjective element of a critical accounting policy. The "hidden funds" can then be put back into the reported profit of a company in a bad quarter. Companies do this because it's a general belief that the ideal company is one that is always consistently and smoothly increasing earnings. For example, a clothing store selling clothing does not show all the profit for a quarter that it made because it knows that some of those clothes will be returned later and it will have to give back the money. To smooth earnings however, management (in a good quarter) can say that they believe that the amount of returns will be high. When they have a bad quarter, they can say that there estimates for the amount of returns was wrong and the amount they say they were wrong by gets added to that quarters profit.

Examples

Some examples of critical accounting policies are:

  • A clothing retailer accounting for inventory taking into consideration the fact that a rough balance of sizes is necessary for any particular piece of clothing on the sales floor
  • Bank's accounting for future unpaid loans
  • A manufacturer or a store accounting for future returned items
  • Mortgage companies accounting for mortgage servicing rights
  • The estimate of bad debts
  • Accounting for the value of derivatives
  • Selecting an appropriate rate and method of depreciation of fixed assets

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