ACCOUNTING POLICIES & FUNDAMENTAL ACCOUNTING ASSUMPTIONS | CAP CLASSES

ACCOUNTING POLICIES

One Question to begin with???

Is it possible to have a single set of accounting policies to be followed by all the enterprises???

Answer: No. It is not possible.

Now it raises the second one. “Why”?

Answer: entities differ in nature and size. Also they operate in different economic, industrial and geographical conditions. The nature of their activities differs. Their operations differ. So, there can’t be one set of Accounting Policies which suits all situations and all applicable to all entities. Therefore, Governments and Accounting bodies (regulatory authorities) give due space to them so that they can choose an accounting policy among available alternatives which best suits them. That means, there are multiple options. This gives rise to three necessities.

a)Choose the one which suits you the best.

b)Follow the same consistently from time to time.

c) Disclose what you are doing.

d)Disclose if there is a change in the policy you adopt.

Choices to pick from:

The accounting standards therefore permit more than one policy. Differences in accounting policies lead to differences in reported information even if underlying transactions are same. (your mind asks, if so, what’s the big deal? Let ‘em do whatever they want). Wait, there is a concern.

The qualitative characteristic of comparability of financial statements therefore suffers due to diversity of accounting policies. Since absolute uniformity is impossible, and accounting standards permit more than one alternative in many cases, it is difficult to understand the impact of diverse accounting policies adopted by different entities, unless they are disclosed.

For these reasons, AS 1, requires enterprises to disclose accounting policies actually adopted by them in preparation of their financial statements. Such disclosures allow the users of financial statements to take the differences in accounting policies into consideration and to make necessary adjustments in their analysis of such statements.

AS-1, Disclosure of Accounting Policies, promotes

a) Better understanding of financial statements by requiring disclosure of significant accounting policies in an orderly manner

b) Such disclosures facilitate meaningful comparison between financial statements of different enterprises for same period.

c)  Disclosures of changes in accounting policies enables users to compare financial statements of same enterprise from one accounting period to other.

Fundamental  Accounting Assumptions

1) Going Concern:

The financial statements are normally prepared on the assumption that an enterprise will continue its operations in the foreseeable future and neither there is intention, nor there is need to materially curtail the scale of operations.

ISA 570: Going Concern explains the responsibilities of auditor to verify whether the entity is a going concern or are there any indications of threat to the going concern assumption.

Also, it is the responsibility of management to disclose in the financial statements, in case, if the financial statements are prepared on a basis other than going concern (liquidation basis)

If the management does so, (as they have fulfilled their responsibility properly, auditor need not modify his report. He will emphasise the matter in his report that the entity has going concern issues)

If the management fails to do so, the auditor modifies the opinion by expressing either a Qualified Report or an Adverse Report (based on the severity of the issue)

2) Consistency:

The principle of consistency refers to the practice of using same accounting policies for similar transactions in all accounting periods. The consistency improves comparability of financial statements through time.

Can an entity change its current accounting policy? The answer is “YES” but not as per the will and wish of management.

An accounting policy can be changed if the change is required

(i)                  by a statute

(ii)                by an accounting standard

(iii)              for more appropriate presentation of financial statements.

3) Accrual basis of accounting:

A junior in your office gets a doubt. When should I record sales? At the point of time when goods are delivered or at the point of time when cash is received?

When should I record expenses?

Should I record them when I incur them or when I pay for the expense incurred.

If you record on the basis of payment or receipt of cash it is “Cash Basis of Accounting” which is not allowed in general.

As per Accrual basis of accounting, transactions are recognised as soon as they occur, whether or not cash or cash equivalent is actually received or paid.

Accrual basis ensures better matching between revenue and cost and profit/loss obtained on this basis reflects activities of the enterprise during an accounting period, rather than cash flows generated by it.

Accrual basis of accounting is followed while recording the transactions because of its logical superiority over cash basis of accounting. Section 128 of the Companies Act, 2013 makes it mandatory for companies to maintain accounts on accrual basis only.

Disclosure of deviations from fundamental accounting assumptions

a)   If the fundamental accounting assumptions, viz. Going concern, Consistency and Accrual are followed in financial statements, specific disclosure is not required.

b)  If a fundamental accounting assumption is not followed, the fact should be disclosed.

Simple to understand:

Your father has a fundamental assumption that you attended college today. If you have attended, your teacher or admin staff from college need not call your father to inform, “Sir, your son / daughter attended college today”. This leads to unnecessary doubts. (It may go up to your suitcase). But if you haven’t attended the college, it is the responsibility of the college to inform your dad that you didn’t turn for the day. So, if assumption holds good, no need to disclose anything. If violated, then disclose.

ACCOUNTING POLICIES

Remember the rule AP = SAP + MAP

The accounting policies refer to the specific accounting principles and the methods of applying those principles adopted by the enterprise in the preparation and presentation of financial statements.

Accountant has to make decisions from various options for recording or disclosing items in the books of accounts e.g.

Sl No	Principle	Method of applying the principle
1	Inventory is to be valued at the lower of a)        Cost b)        NRV	How the cost is determined? It can be based on a)        Specific Identification Method b)        Standard Cost Method c)        Retail Method d)        FIFO e)        Weighted Average Method
Both the above i.e., the principle and method of applying the same, put together, is known as the accounting policy of the company.

For every item right from valuation of assets and liabilities to recognition of revenue, providing for expected losses, for each event, accountant need to form principles and evolve a method to adopt those principles. This method of forming and applying accounting principles is known as accounting policies.

Selection of Accounting Policy

There are two considerations in choosing an accounting policy for a given transaction in a given situation. They are

Primary Consideration	Other Major considerations (Remember, standard didn’t say secondary considerations)
Financial Statements prepared based on those accounting policies should portray “True and Fair View”.	1.     Prudence
	2.     Substance over form
	3.     Materiality
	(they are explained in detail below)

1) Prudence:

It’s Simple!!! Be conservative, while accounting. Accountant is trained to be conservative, not to be aggressive while reporting profits or financial position. So, don’t record anticipated profits but account for anticipated losses, as a matter of conservatism.

Provision should be created 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.

The exercise of prudence in selection of accounting policies ensure that

(i)                  profits are not overstated

(ii)                losses are not understated

(iii)              assets are not overstated and

(iv)               liabilities are not understated.

2) Substance over form:

Substance means Economic Reality. Form means legal reality.

For example, you bought a car by taking loan from ICICI Bank. On the registration certificate (RC), it shows the name of ICICI Bank as the owner. But Remember:

a)  ICICI will not record car as asset in their books and claim depreciation (though they are legally the owners) [you will have a question, then how? What’s the accounting? Simple, they have an asset equivalent which is “YOU, the debtor”

b)   You will  record car as an asset in your books and claim depreciation (though it is not legally registered in your name)

This is a classic example for substance over form. If you look at the above accounting, transaction is not recorded based on legal reality but it is recorded on the basis of economic reality.

Transactions and other events should be accounted for and presented in accordance with their substance and financial reality and not merely with their legal form.

3) Materiality:

All accounting standards are applicable to material items. That means if the item is not material, even if there is a deviation from the accounting standard also, it doesn’t matter. It won’t affect the true and fair view. And guess what? Auditor is also not bothered about such a deviation from the accounting standards as it is not material.

Now what is materiality?

An item is material if its omission or erroneous presentation will affect the economic decisions of the users of the financial statements.

For example, an organisation purchased pen, pencil, scale, eraser and a note book from a stationery shop for Rs. 90. Whether they present this 90 rupees as office maintenance, printing and stationery, miscellaneous expenses or under any other head, the user of P&L is not affected by it. It’s not material by nature, neither material by size and doesn’t need a separate place in P&L.

Financial statements should disclose all ‘material items, i.e. the items the knowledge of which might influence the decisions of the user of the financial statement. Materiality is not always a matter of relative size.

Manner of disclosure:

All significant accounting policies adopted in the preparation and presentation of financial statements should be disclosed.

Remember:

Disclose all significant accounting policies

a)       All in one place

b)       Inside the financial statements.

 

Disclosure of Changes in Accounting Policies

Any change in the accounting policies which has a material effect in the current period or which is reasonably expected to have a material effect in a later period should be disclosed.

In the case of a change in accounting policies, which has a material effect in the current period, the amount by which any item in the financial statements is affected by such change should also be disclosed to the extent ascertainable. Where such amount is not ascertainable, wholly or in part, the fact should be indicated.