Disclosure of Accounting Policies - Simplified form

Accounting Standard 1 issued by ICAI

Disclosure of Accounting Policies

Introduction:

The standard deals with what, where, which and how accounting policies should be disclosed. The accounting policies are set of principles, methods and procedures applied by management in preparation of financial statements. One can think of it as basic assumptions taken into consideration which should not be outside the purview of the general accounting principles. The financial statements provide information to users, suppliers and many others that use them to take decision whether to invest into the shares of the company or whether to supply raw material to a company and many more decisions. A lay man may not take into consideration the policies while reviewing financial statements or the reports which an investor receives at the end of every year but for an analyst it seems to be very important as he or she compares it with the other entities in the industry.

Background:

ICAI recommends certain disclosures of accounting policies while preparation and presentation of financial statements. In general all the policies cannot be disclosed in the annual report but the important ones that can affect the decisions of the users of financial statements need to be disclosed. The main purpose is to enable comparison and better understanding of financial statements of various entities operating in the industry. There is no list of comprehensive accounting policies as various entities operate in different industrial and sectorial environment.

The choice as to whether to charge depreciation on fixed assets by SLM method or by WDV and various other choices of valuation of items in the Balance Sheet depends on the judgment of the makers of the financial statement which is the management. If the below mentioned assumptions are not considered they need to disclose it and we can think of them as material items. Assumptions in preparation of financial statements An accountant indirectly takes into consideration certain assumptions or we can say that not much focus is given on these basic assumptions as they are considered by an accountant at the back of their mind. Management considers these as basic rules in preparation of financial statements and users also assume that they are followed. If they are not followed a disclosure is necessary by way of notes in the financial statement at a place which attracts the attention of the reader.

There are three such assumptions or assumed concepts while preparation of financial statements. They are going concern, consistency and accrual.

Going concern - For a student I can explain in the following way; "a firm is assumed to continue year after year." That is why a profit and loss account is prepared for year which can be a suitable time period for comparison of earnings. If it is more than a year than it can be difficult to ascertain and compare, thus an easy way of earning comparison is on a year on year basis. Also from another point of view we see that the Closing stock represented in the trading account of profit and loss account and on the Asset side of Balance Sheet for a year becomes an Opening stock of the next year. We carry forward cash and bank account balance next year. Creditors and Debtors balance are also carried forward next year. Well all of the above statements do qualify to explain the going concern concept that a firm is assumed to continue its operations in future.

Consistency - For a student I can explain it as; "what you have done in past, you continue to do it in future." There is always a resistance to change and human behavior is such that it does not accept changes too soon. The same qualifies for accounting policies. The methods of depreciation are kept same year on year. This also facilitates better comparison of earnings year on year for an analyst.

Accrual - This takes into consideration the conservatism behavior of an accountant. They record the expenses as soon as they incur but record the revenue only when it is received. But the matching principle comes into play over here and thus the concept of revenue recognition. However this concept is not dealt in this standard. Selection of appropriate accounting policies The primary consideration is true and fair view of the statement of income and statement of affairs. The below three considerations are equally important.

Prudence - Profits are recognized as they are realized but loss if anticipated is provided for earlier. One can think of it as a father who wishes to accumulate an amount in future to finance his son's future education and he has also bought a lottery ticket. He will start saving now. He will not wait for a lottery income. When he receives his lottery income he can stop saving.

Substance over Form - Think in terms of depreciation of building which you have bought but registration is still pending. You will charge depreciation as you wish to reduce your income and pay less tax. But as per Income tax Act, 1961, the depreciation can be charged by the owner of an asset. In this case the transaction is governed by the substance. You own the asset and registration is just a legal formality.

Materiality - How would you feel if the culture in the company you are working encourages withholding of information. Your colleague withholds the information which if you would have received in advance could have saved your job. Materiality is related to that type of information which when received by the user of financial statement, he could change his decision for his benefit.

Conclusion:

You cannot do something wrong and just say that you have done wrong in accounts. In the same why if you disclose an accounting policy which is not as per general accounting principle, you cannot claim that the treatment for the item to which it pertains is correct since a disclosure is made at appropriate place. Thus we answer the major "w" type question. What - All major accounting policies should be disclosed. Where - They should be disclosed generally at a place which can hold the attention of the user of financial statement Which - Any change in policy that has an impact on basis of principle of materiality should be disclosed and if the principles of going concern, consistency and accrual are not followed. How - By notes to accounts.