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Understanding AS-1 with Illustrations

AS 1 : DISCLOSURE OF ACCOUNTING POLICIES

Introduction

The purpose of Accounting Standard 1, Disclosure of Accounting Policies, is to promote better understanding of financial statements by requiring disclosure of significant accounting policies in orderly manner. Such disclosures facilitate more meaningful comparison between financial statements of different enterprises for same accounting periods. The standard also requires disclosure of changes in accounting policies such that the users can compare financial statements of same enterprise for different accounting periods.

Fundamental Accounting Assumptions

Fundamental Accounting Assumptions

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. Financial statements prepared on going concern basis recognise among other things the need for sufficient retention of profit to replace assets consumed in operation and for making adequate provision for settlement of its liabilities.

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. 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.

Accrual basis of accounting: Under this 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.

While accrual basis is a more logical approach to profit determination than the cash basis of accounting, it exposes an enterprise to the risk of recognising an income before actual receipt. The accrual basis can therefore overstate the divisible profits and dividend decisions based on such overstated profit lead to erosion of capital. For this reason, accounting standards require that no revenue should be recognised unless the amount of consideration and actual realisation of the consideration is reasonably certain.

Despite the possibility of distribution of profit not actually earned, accrual basis of accounting is generally followed because of its logical superiority over cash basis of accounting as illustrated below. Section 128(1)(iii) of the Companies Act makes it mandatory for companies to maintain accounts on accrual basis only. It is not necessary to expressly state that accrual basis of accounting has been followed in preparation of a financial statement. In case, any income/expense is recognised on cash basis, the fact should be stated.

Accounting Policies

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.

Items to be disclosed

Method of disclosure or valuation

Inventories

FIFO, Weighted Average etc.

Cash Flow Statement

Direct Method, Indirect Method

Depreciation

Straight Line Method, Reducing Balance Method, Depletion Method etc.

This list is not exhaustive i.e. endless. 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

Financial Statements are prepared to portray a true and fair view of the performance and state of affairs of an enterprise. In selecting a policy, alternative accounting policies should be evaluated in that light. In particular, major considerations that govern selection of a particular policy are:

Prudence: In view of uncertainty associated with future events, profits are not anticipated, but losses are provided for 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.

Example 1

The most common example of exercise of prudence in selection of accounting policy  is the policy of valuing inventory at lower of cost and net realisable value.

Suppose a trader has purchased 500 units of certain article @ 10 per unit. He sold 400 articles @ 15 per unit. If the net realisable value per unit of the unsold article is 15, the trader should value his stock at 10 per  unit  and  thus ignoring the  profit 500 that he may earn in next accounting period by selling 100  units of  unsold articles. If the net realisable value per unit of the unsold article is 8, the trader should value his stock at 8 per unit and thus recognising possible loss 200 that he may incur in next accounting period by selling 100 units of unsold articles.

Profit of the trader if net realisable value of unsold article is 15

= Sale – Cost of goods sold = (400 x 15) – (500 x 10 – 100 x 10) = 2,000 Profit of the trader if net realisable value of unsold article is 8

= Sale – Cost of goods sold = (400 x 15) – (500 x 10 – 100 x 8) = 1,800

Example 2

Exercise of prudence does not permit creation of hidden reserve by understating profits and assets or by overstating liabilities and losses. Suppose a company is  facing a damage suit. No provision for damages should be recognised by a charge against profit, unless the probability of losing the suit is more than the probability of not losing it.

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

Materiality: 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. For example a small amount lost by fraudulent practices of certain employees can indicate a serious flaw in the enterprise’s internal control system requiring immediate attention to avoid greater losses in future. In certain cases quantitative limits of materiality is specified. A few of such cases are given below:

  • A company should disclose by way of notes additional information regarding any item of income or expenditure which exceeds 1% of the revenue from operations or ₹1,00,000 whichever is higher.
  • A company should disclose in Notes to Accounts, shares in the company held by each shareholder holding more than 5 per cent shares specifying the number of shares held.

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

The disclosure of the significant accounting policies as such should form part of the financial statements and the significant accounting policies should normally be disclosed in one place.

Note: Being a part of the financial statement, the opinion of auditors should cover the disclosures of accounting policies.

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.

Change in Accounting Policy

Example 3

A simple disclosure that an accounting policy has been changed is not of much use for a reader of a financial statement. The effect of change should therefore be disclosed wherever ascertainable. Suppose a company has  switched  over  to weighted average formula for ascertaining cost of inventory, from the  earlier  practice of using FIFO. If the closing inventory by FIFO is 2 lakh and that by weighted average formula is 1.8 lakh, the change in accounting policy pulls down profit and value of inventory by 20,000. The company may disclose the change in accounting policy in the following manner:

‘The company values its inventory at lower of cost and net realisable value. Since  net realisable value of all items of inventory in the current year was greater than respective costs, the company valued its inventory at cost. In the present year the company has changed to weighted average formula, which better reflects the consumption pattern of inventory, for ascertaining inventory costs from the earlier practice of using FIFO for the purpose. The change in policy has reduced profit and value of inventory by 20,000’.

A change in accounting policy is to be disclosed if the  change  is  reasonably expected to have material effect in future accounting periods, even  if the  change  has no material effect in the current accounting period.

The above requirement ensures that all important changes in accounting policies are actually disclosed. Suppose a company makes provision for warranty claims based on estimated costs of materials and labour. The company changed the policy in 2014-15 to include overheads in estimating costs for servicing warranty claims. If value of warranty sales in 2014-15 is not significant, the change in policy will not have any material effect on financial statements of 2014-15. Yet, the company must disclose the change in accounting policy in 2014-15 because the change can affect future accounting periods when value of warranty sales may rise to a significant level. If the disclosure is not made in 2014-15, then no disclosure in future years will be required. This is because an enterprise has to disclose changes in accounting policies in the year of change only.

Disclosure of deviations from fundamental accounting assumptions

If the fundamental accounting assumptions, viz. Going concern, Consistency and Accrual are followed in financial statements, specific disclosure is not required. If a fundamental accounting assumption is not followed, the fact should be disclosed. The principle of consistency refers to the practice of using same accounting policies for similar transactions in all accounting periods.

Illustration 1

In the books of M/s Prashant Ltd., closing inventory as on 31.03.2015 amounts to 1,63,000 (on the basis of FIFO method).

The company decides to change from FIFO method to weighted average method for ascertaining the cost of inventory from the year 2014-15. On the basis of weighted average method, closing inventory as on 31.03.2015 amounts to 1,47,000. Realisable value of the inventory as on 31.03.2015 amounts to 1,95,000.

Discuss disclosure requirement of change in accounting policy as per AS-1.

Solution

As per AS 1 “Disclosure of Accounting Policies”, any change in  an  accounting policy which has a material effect should be disclosed in the financial statements. 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. Thus Prashant Ltd. should disclose the change in valuation method of inventory and its effect on financial statements. The company may disclose the change in  accounting policy  in the following manner:

‘The company values its inventory at lower of cost and net realisable value. Since net realisable value of all items of inventory in the current year was greater than respective costs, the company valued its inventory at cost. In the present year i.e. 2014-15, the company has changed to weighted average method, which better reflects the consumption pattern of inventory, for ascertaining inventory  costs from the earlier practice of using FIFO for the purpose. The change in policy has reduced current profit and value of inventory by ₹ 16,000.

Illustration 2

ABC Ltd. was making provision for non-moving inventories based on issues for the last 12 months up to 31.3.2016.

The company wants to provide during the year ending 31.3.2017 based on technical evaluation:

Total value of inventory

100 lakhs

Provision required based on 12 months issue

3.5 lakhs

Provision required based on technical evaluation

2.5 lakhs

Does this amount to change in Accounting Policy? Can the company change the method of provision?

Solution

The decision of making provision for non-moving inventories on the basis of technical evaluation does not amount to change in accounting policy. Accounting policy of a company may require that provision  for  non-moving  inventories should be made. The method of estimating the amount of provision may be changed in case a more prudent estimate can be made.

In the given case, considering the total value of inventory, the change in the amount of required provision of non-moving inventory from ₹ 3.5 lakhs to ₹ 2.5 lakhs is also not material. The disclosure can be made for such change in the following lines by way of notes to the accounts in the annual accounts of ABC Ltd. for the year 2016-17:

“The company has provided for non-moving inventories on the basis of technical evaluation unlike preceding years. Had the same method been followed as in the previous year, the profit for the year and  the corresponding effect on  the year end net assets would have been lower by ₹ 1 lakh.”

Illustration 3

Jagannath Ltd. had made a rights issue of shares in 2017. In  the offer document to  its members, it had projected a surplus of 40 crores during the accounting year to end on 31st March, 2017. The draft results for the year, prepared on the hitherto followed accounting policies and presented for perusal of the board of directors showed a deficit of 10 crores. The board in consultation with the managing  director, decided on the following:

  1. Value year-end inventory at works cost ( 50 crores) instead of the hitherto method of valuation of inventory at prime cost ( 30 crores).
  2. Provide depreciation for the year on straight line basis on account of substantial additions in gross block during the year, instead  of  on  the reducing balance method, which was hitherto adopted. As a consequence, the charge for depreciation at 27 crores is lower than the amount of 45 crores which would have been provided had the old method been followed, by 18crores.
  3. Not to provide for “after sales expenses” during the warranty Till the last year, provision at 2% of sales used to be made under the concept of “matching of costs against revenue” and actual expenses used to be charged against the provision. The board now decided to account for expenses as and when actually incurred. Sales during the year total to 600 crores.
  4. Provide for permanent fall in the value of investments – which fall had taken place over the past five years – the provision being ₹ 10.

As chief accountant of the company, you are asked by the managing director  to  draft the notes on accounts for inclusion in the annual report for 2016-2017.

Solution

As per AS 1, 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  later periods 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. Accordingly, the notes on accounts should properly disclose the change and its effect.

Notes on Accounts:

  1. During the year inventory has been valued at factory cost, against the practice of valuing it at prime cost as was the practice till last year. This has been done to take cognisance of the more capital intensive method of production on account of heavy capital expenditure during the year. As a result of this change, the year-end inventory has been valued at ₹ 50 crores and the profit for the year is increased by ₹ 20 crores.
  2. In view of the heavy capital intensive method of production introduced during the year, the company has decided to change the method of  providing depreciation from reducing balance method to straight line As a result of this change, depreciation has been provided at ₹ 27 crores which is lower than the charge which would have been made had the old method and the old rates been applied, by ₹ 18 crores. To that  extent, the profit for the year is increased.
  3. So far, the company has been providing 2% of sales for meeting “after sales expenses during the warranty period. With the improved method of production, the probability of defects occurring in the products has reduced Hence, the company has decided not to make provision for such expenses but to account for the same as and when expenses are incurred. Due to this change, the profit for the year is increased by ₹ 12 crores than would have been the case if the old policy were to continue.
  4. The company has decided to provide ₹ 10 crores for  the permanent fall in the value of investments which has taken place over the period of past five The provision so made has reduced the profit disclosed in  the  accounts by ₹ 10 crores.

Illustration 4

XYZ Company is engaged in the business of financial services and is undergoing  tight liquidity position, since most of the assets of the company are blocked  in various claims/petitions in a Special Court. XYZ has accepted Inter-Corporate Deposits (ICDs) and, it is making its best efforts to settle the  dues.  There  were  claims at varied rates of interest, from lenders, from the due date  of  ICDs to the  date of repayment. The company has provided interest, as per the terms of the contract till the due date and a note for non-provision of interest on the due date to date of repayment was affected in the financial statements. On account of uncertainties existing regarding the determination of the amount and  in  the  absence of any specific legal obligation at present as per the terms of contracts, the company considers that these claims are in the nature of “claims against the company not acknowledged as debt”, and the same has been disclosed by way of a note in the accounts instead of making a provision in the profit and loss accounts. State whether the treatment done by the Company is correct or not.

Solution

AS 1 ‘Disclosure of Accounting Policies’ recognises ‘prudence’ as one of the major considerations governing the selection and application of accounting policies. 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.

Also as per AS 1, ‘accrual’ is one of the fundamental accounting assumptions. Irrespective of the terms of the contract, so long as the principal amount of a loan  is not repaid, the lender cannot be replaced in a disadvantageous position for non-payment of interest in respect of overdue amount. From the aforesaid, it is apparent that the company has an obligation on account of the overdue interest.  In this situation, the company should provide for the liability (since it is not waived by the lenders) at an amount estimated or on reasonable basis based on facts and circumstances of each case. However, in respect of the overdue interest amounts, which are settled, the liability should be accrued to the extent of  amounts settled. Non-provision of the overdue interest liability amounts to violation of accrual basis of accounting. Therefore, the treatment, done by the company, of not providing the interest amount from due date to the date of repayment is not correct.

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