Disclosure of Accounting Policies
(One part of AS 5 that deals with Changes in Accounting Policies is also included)
Accounting Standard 1, titled Disclosure of Accounting Policies, lays down the meaning of what is an accounting policy and the procedures for selecting and adopting accounting policies. The related accounting issue of when and for what purpose the accounting policy can be changed is dealt with only in Accounting Standard 5, titled Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies.
In this article, the aspect of change in accounting policy, drawn from Accounting Standard 5, has also been incorporated so that the picture is complete.
Accounting Standard 1 requires reporting entities to select and adopt appropriate accounting policies, with due regard to the fundamental accounting assumptions of Going Concern, Consistency and Accrual Basis of accounting.
The entities should also ensure that the financial statements reflect a true and fair view of the state of affairs and financial position of the entity. Prudence, substance over form, and materiality should form the main considerations in selecting and applying accounting policies.
Accounting Standard 1 also requires that accounting policies adopted by enterprises should be disclosed in one place, such that it forms a part of financial statements. Changes introduced in accounting policies and the monetary effect of such changes should also be disclosed.
Accounting Standard 5 (Net Profit or Loss for the Period, Prior period items and Changes in Accounting Policies) lays down three conditions under which a reporting entity can change its accounting policies and what disclosures should be made in this regard.
Accounting Standard 1 applies in full to all SMCs, as also to all non-company entities falling in the categories of Level I to Level IV entities. The Standards are operative for all accounting periods commencing on or after 1st April 2021.
The task of accounting revolves around the quantum and timing of including revenues and costs in P&L and the decisions on whether an expenditure would be treated as an asset or expense. In other words, what are the determinants that prompt the inclusion of material items in P&L or BS?
The implication is that in the practical world of accounting, there exists today more than one seemingly legitimate accounting treatment. A properly formulated accounting policy provides an answer and assists the stakeholders in taking a comparative view in their decision-making process.
Fundamental Accounting Assumptions
Accounting Standard 1 emphasises that there are three assumptions (concepts) that are fundamental to accounting.
First is the concept of Going Concern:
While the economic activities of enterprises continue uninterruptedly, there exists a practice of presenting financial information with reference to an accounting period, partitioned in time. This practice carries a supposition that the activities of the reporting entity will continue beyond the period for which financial position and performance are reported.
The Going Concern concept is a necessary corollary to this accounting practice. In simple words, this term means that the reporting entity is expected to continue in business, and there are no signs that prove otherwise. In Paragraph 3.9, the Conceptual Framework clarifies the term Going Concern.
The financial statements are typically prepared on the assumption that the reporting entity is a going concern and will continue in operation for the foreseeable future. Hence it is assumed that the entity has neither the intention nor the need to enter liquidation or cease trading. If such an intention or need exists, the financial statements may have to be prepared on a different basis, and if so, the basis on which the financial statements have been prepared should be disclosed.
If an enterprise is faced with a need to close down or scale down its operations to a significant extent, an altogether different basis must be adopted in preparing financial statements. That is, the value of assets and amounts of obligations would require to be readjusted to represent the values that would emerge if the enterprise were to close down its operations.
In certain circumstances, the sale by an enterprise of its assets substantially in its entirety can affect the validity of the going concern assumption. In short, assets are to be stated at realisable values, and liabilities are to be stated at settlement amounts.
Sub-section (iv) of S. 134(3)(c) of the Companies Act 2013 casts a responsibility on the Directors of a Company to declare (if that be the case) that the accounts are prepared on a Going Concern basis. What is appropriate for companies is equally relevant for other forms of legal entities. The need to reaffirm the continued validity of the Going Concern assumption also emanates from the prescriptions in the Standard on Auditing No.570.
Second is the concept of Consistency:
The assumption, in this case, is that there should be a consistency of accounting treatment for various items. Consistency, although related to comparability, is not the same. The term consistency refers to the use of the same methods for the same items, either from period to period or in a single period across entities. Comparability is the goal. Consistency helps to achieve that goal.
Companies Act also contains provisions requiring reporting entities to incorporate corresponding financial information in respect of the preceding financial year so that stakeholders can take a view by comparing the two sets of figures. Unless the principles followed or accounting methods adopted are consistent from year to year, the comparability of information gets distorted. This principle of consistency is so plain in its basics that it hardly needs any elaboration.
The third concept is the accrual basis of accounting:
ICAI’s GN, on the Terms used in Financial Statements, defines this phrase as follows. The accrual basis of accounting is a method of recording transactions by which revenues, costs, assets and liabilities are reflected in the accounts in the period in which they accrue.
The ‘accrual basis of accounting’ includes considerations relating to deferrals, allocations, depreciation and amortisation. This basis is also referred to as the mercantile basis of accounting.
Two elements assist in the determination of profit as a measure of performance. The first element is revenue. The second is cost. Accounting Standard 1 highlights both these elements. Revenues and costs are accrued that are recognised as they are earned or incurred (and not as money is received or paid) and recorded in the financial statements of the periods to which they relate.
It follows, therefore, that where the accrual basis of accounting is adopted, besides accrued revenue and accrued expense, accrued asset and accrued liability items can also emerge.
These three concepts, which are fundamental to accounting, are the broad-based assumptions that govern the preparation of financial statements periodically. It is always assumed that financial statements are prepared by enterprises in strict adherence to these fundamental concepts.
The term Accounting Policy is defined in Accounting Standard 5 (Net Profit or Loss for the period, Prior period items and Changes in Accounting Policies). Accounting Policies are specific accounting principles and the methods enterprises adopt in applying these principles in preparing and presenting financial statements.
Whereas the principle that supports the resolution of an accounting issue could be the same, the manner in which the accounting issue gets resolved lies in the choice of the method.
Many Standards specify more than one method for implementing an accounting principle. For example, for recognising revenues and costs in respect of construction contracts, the principle of percentage of completion is to be adopted. In turn, the percentage of completion can be derived by selecting the cost method, survey method or units of production method as relevant. At times, these methods are also referred to as accounting bases.
Because there can be more than one recognised accounting base for an individual accounting issue, it is essential for reporting entities to select only those that are most appropriate in the given circumstances. The accounting policies selected and adopted by reporting entities should conform to the principles of Accounting Standards.
True and Fair View
Accounting Standard 1 requires that the accounting principles and methods selected by an entity should represent a true and fair view of the state of affairs of the entity as at the reporting date and of the profit or loss for the period ended on the reporting date.
In a broad sense, a true and fair view is deemed to be achieved when
- the accounting principles selected and applied have general acceptance
- the policies are appropriate in the given set of circumstances
- the financial statements, including the related notes, provide sufficient and appropriate information on matters that may affect their use, understanding and interpretation, and
- the financial position, results of operations, and cash flows faithfully represent the underlying transactions and events and are also in conformity with the accounting Standards.
Section 143(2) of the Companies Act 2013 also prescribes that the financial statements in respect of which the auditor makes his report should depict a “True and Fair View”. This term should be understood to mean that the financial statements should present an unbiased appreciation of facts regarding
(a) the real resources and claims against those resources and
(b) the earnings which have arisen from the use of resources of the enterprise through the accounting period. Any presentation that achieves this objective can be said to have provided a true and fair view.
The issue of true and fair view is a widely discussed topic. International Accounting Bodies (IASB etc.) are slowly but surely digressing from this concept by taking the view that other terms, such as fairly reflects or fair presentation, convey the same meaning.
Considerations governing the selection of Accounting Policies
Accounting Standard 1 highlights three major considerations that should support the selection of accounting policies. These are
- Substance over form and
Prudence is the inclusion of a degree of caution in the exercise of judgment needed in making accounting estimates under conditions of uncertainty. By exercising prudence, an enterprise does not recognise profits that are anticipated to emerge at a future date. These are recognised only when realised though not necessarily in cash.
In contrast, a provision is made for all known liabilities or losses. Basically, the reporting entities should exercise care to ensure that the policies selected reflect conservatism. The focus should be not to overstate assets and income or understate liabilities and expenses.
Substance over form:
The carrying amounts of assets and the value of obligations in the balance sheet should be reliable. Reliability can be ensured only if financial information faithfully represents the transactions and events it purports to portray. The substance of the transaction – rather than its form – therefore assumes importance.
Thus, accounting policies should reflect the substance of transactions and not depict what is apparent from the legal or contrived form. This norm stands incorporated in many standards.
Examples include combining and segmenting contracts; revenue is recognised not necessarily when the legal ownership of goods is transferred but when control is transferred; the lease is classified as a finance lease based on the substance of the lease arrangement, and consolidated financial statements are presented to depict the financial position of more than one entity, as that of a single economic entity. Accounting policies selected should conform to this norm.
Materiality is a model that not merely fits in the selection of accounting policies but has a pervasive relevance for the application of all the Standards. The requirements in the Accounting Standards are intended to apply only to items that are material. It is difficult to define the term materiality.
One can say that if, in the preparation and presentation of financial statements, some information is either omitted or misstated in a way that it could influence the decisions of users, then one should reckon that information as material.
Auditing Standard SA 320 (Materiality in Planning and Performing an Audit) deals with this concept and prescribes guidelines to be adhered to by the auditor.
SA 320 clarifies that misstatements, including omissions, are considered to be material if they, individually or in the aggregate, could reasonably be expected to influence the economic decisions of users taken on the basis of the FS.
Further, judgments about materiality are made in the light of surrounding circumstances and are affected by the size or nature of a misstatement or a combination of both; and Judgments about matters that are material to users of the FS are based on a consideration of the common needs of users as a group.
Materiality is one of the most complex, pervasive and elusive components of accounting theory. Making materiality decisions calls for considerable judgment. To the delight (or perhaps even dismay) of some, it is not either possible or necessary to develop a comprehensive set of criteria to evaluate materiality dilemmas.
Materiality should be considered at both the overall financial information level and in relation to individual account balances and classes of transactions. Materiality may also be influenced by other considerations, such as the legal and regulatory requirements, non-compliance with which may have a significant bearing on the financial information.
A uniform threshold level for various items in BS or P&L cannot be and has not been prescribed, and this is a call of judgement.
In selecting accounting policies, every reporting entity should pay attention to these three major considerations outlined above. Nevertheless, other qualitative characteristics of accounting information, such as (i) relevance, (ii) reliability, (iii) completeness, and (iv) neutrality, cannot be ignored and should also be kept in view
Effecting a change in accounting policy:
This topic has been dealt with only in Accounting Standard 5 but is introduced here in order to ensure continuity and cohesiveness.
A change in Policy:
The term “change” means the act or result of becoming different. There are circumstances when a change in accounting policy is not deemed to have occurred.
Two possible situations are covered.
First is that the adoption of an accounting policy for events or transactions that differ in substance from previously occurring events or transactions is not deemed to be a change in accounting policy. The Standard cites the example of an enterprise introducing a formal retirement gratuity scheme in place of ad hoc ex-gratia payments to employees on retirement is not deemed as a change in accounting policy.
Second is that adopting a new accounting policy for events or transactions that did not occur previously or were considered immaterial is not a change.
Accounting Standard 5 prescribes that an entity can make a change in its accounting policy only under three circumstances, namely,
(a) if such a change is warranted by Statutory requirements
(b) if such a change is to ensure conformity with the pronouncements of ICAI, or
(c) the change aims at a more appropriate presentation.
The implication is that an entity cannot change its accounting policy “at will”, and such an act would be deemed to be in violation of the principle of consistency.
The first two conditions (i.e., the reason for the change being a statutory need or in compliance with new pronouncements of ICAI) are fairly easy to understand.
The term “more appropriate presentation” means that the changed or revised accounting policy aims to enhance the relevance and reliability of the information contained in the financial statements.
To put it differently, any voluntary change in accounting policy should add value to users in terms of predictive value, confirmatory or feedback value, timeliness, representational faithfulness, verifiability and neutrality. A voluntary change is therefore expected to result in an improvement in all these qualitative characteristics of accounting information presented.
It is reiterated that a reporting entity cannot bring about a change in accounting policy for reasons other than the three mentioned above.
Disclosure of Accounting Policies:
The disclosure requirements in Accounting Standard 1 and those in Accounting Standard 5 are given below:
- All the significant accounting policies should be disclosed. The term ‘significant accounting policies’ can be explained as those accounting policies by applying which (in recognition of transactions and events) the impact on performance or financial position would be of sufficient magnitude. These should be disclosed in one place.
- These disclosures should form a part of financial statements
- If any of the three fundamental accounting assumptions (Going Concern, Consistency and Accrual) is not followed, such a fact should be disclosed.
- If the entity has effected a change in accounting policy, then this aspect requires to be disclosed, along with the impact of and the adjustments resulting from such a change, if material, should be disclosed.
Where the effect of such change is not ascertainable, wholly or in part, the fact should be indicated.
If a change is made in the accounting policies which has no material effect on the financial statements for the current period but which is reasonably expected to have a material effect in later periods, the fact of such change should be appropriately disclosed in the period in which the change is adopted.
Click here to read the text of Accounting Standard 1
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