As per AS-1 issued by the ICAI, the primary considerations in selection of accounting policies of an enterprise should be 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 of the enterprise as at the balance sheet date and of the profit.
For this purpose, the major considerations governing the selection and application of accounting policies, as specifically outlined in AS-1 are as under:
In view of the uncertainty attached to future events, profits are not anticipated but recognised only when realised though not necessarily in cash. Provision is made for all known liabilities and losses even though the amount cannot be determined with certainty and represents only a best estimate in the light of available information.
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.
b. Substance over Form
The accounting treatment and presentation in financial statements of transactions and events should be governed by their substance and not merely by the legal form.
Financial information should represent the actual transactions and hence it is necessary accounting and presentation 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, i.e. items the knowledge of which might influence the decisions of the user of the financial statements.
‘Relevance’ is a qualitative part whereas ‘materiality’ is a quantitative part of the financial information. 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 mis-information or not, is linked with the size and nature of the error in presenting an item in the financial statement.