As per AS-1 issued by the ICAI, the primary considerations in selection of accounting policies should be to ensure that the financial statements prepared and presented on the basis of such accounting policies should represent a true and fair view of the state of affairs (assets/ liabilities) of the enterprise as on the balance sheet date and of the profit or loss for the financial period ended on that date. Accordingly, the ICAI has specifically outlined the major considerations in AS-1, i.e. Prudence, Substance over Form and Materiality, which shall govern the selection and application of accounting policies:
Financial Statements/ Information is always subject to many uncertainties, like realisability of receivables, remaining useful life of assets, etc. Such uncertainties are not only disclosed in the financial statements but also are handled with ‘prudence’ during the process of preparation thereof. Prudence is applied while making estimates/ provisions for uncertain conditions, to ensure that neither the assets/ income are overstated nor the liabilities/ expenses are understated.
In the process, prudence does not allow creation of hidden reserves, excessive provisions, deliberate understatement of assets/ income or deliberate overstatement of liabilities/ expenses, to maintain quality of reliability.
Substance over Form
Financial information should represent the actual transactions and hence it is necessary that the accounting treatment and presentation in financial statements should be based on their ‘substance’ (i.e. economic/ financial reality) and not just based on their legal form.
For example, where a piece of land has been sold but the documentation and legal formalities are pending at the year end, recording of transaction can’t be held up for want of a legal document, both in the hands of the seller as well as the buyer. The transaction has to be recorded using the concept of ‘substance over form’.
Financial statements should disclose all material items, which might influence the decisions of the user of the financial statements.
Financial information is considered as ‘material’, if it can substantially (beyond a cut-off/ threshold) influence the process of decision making of the user thereof. Determination of ‘materiality’ is quite subjective and is decided on a case to case basis. Material misinformation or not, is linked with the size and nature of the error in presenting an item in the financial statement.
It may be noted that the ‘Relevance’ and ‘Materiality’ are different in the sense that they represent ‘qualitative’ and ‘quantitative’ parts of any financial information, respectively.
ICAI's AS-1 Related Posts:
To know about the 'primary considerations' in 'Selection of Accounting Policies':
To know about the 'Nature' and 'Disclosure' of Accounting Policies:
To know about the situations where different accounting polices may be adopted:
To know about what are the fundamental accounting assumptions:
To know more about the accounting standards issued by the ICAI: