5(a) Using appropriate examples, explain how each of these concepts guide accounting

practice. Prudence, Substance over Form, Materiality:

Accounting policies

Accounting policies refer to accounting principles and the methods of applying these principles
adopted by the organisation in the preparation of their financial statements. There is no single list
of accounting policies that are applicable in all circumstances. The different circumstances in
which organisations operate make alternative accounting principles acceptable. The choice of the
appropriate accounting principles calls for a large degree of judgement by the management of the
organisation.

Accounting policies can be used to legally manipulate earnings. For example, companies are
allowed to value inventory using the average cost, first in first out (FIFO) , or last in first out
(LIFO) methods of accounting.

Disclosure of accounting policies should identify and describe the accounting principles
followed by the reporting entity and the methods of applying those principles that materially
affect the determination of financial position, cash flows, or results of operations.

Any change in an accounting policy which has a material effect should be disclosed . 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.

Considerations in the Selection of Accounting Policies

The primary consideration in the selection of accounting policies by an organisation is that the
financial statements should represent a true and fair picture of the financial position for the
period. For this purpose, the major considerations governing the selection and application of
accounting policies are:

a) Prudence

Under the prudence concept, do not overestimate the amount of revenues recognized or
underestimate the amount of expenses. Also, one should be conservative in recording the amount
of assets, and not underestimate liabilities. The result should be conservatively-stated financial
statements.

Another way of looking at prudence is to only record a revenue transaction or an asset when it is
certain, and record an expense transaction or liability when it is probable. In addition, you would
tend to delay recognition of a revenue transaction or an asset until you are certain of it, whereas
you would tend to record expenses and liabilities at once, as long as they are probable. Also,
regularly review assets to see if they have declined in value, and liabilities to see if they have
increased. In short, the tendency under the prudence concept is to either not recognize profits or
to at least delay their recognition until the underlying transactions are more certain.

Prudence would normally be exercised in setting up, for example, an allowance for doubtful
accounts or a reserve for obsolete inventory. In both cases, a specific item that will cause an
expense has not yet been identified, but a prudent person would record a reserve in anticipation
of a reasonable amount of these expenses arising at some point in the future.

Generally the prudence concept is incorporated in many accounting standards, which (for
example) require you to write down fixed assets when their fair values fall below their book
values, but which do not allow you to write up fixed assets when the reverse occurs. International
Financial Reporting Standards do allow for the upward revaluation of fixed assets, and so do not
adhere quite so rigorously to the prudence concept.

The prudence concept is only a general guideline. Ultimately, use your best judgment in
determining how and when to record an accounting transaction.

b) Substance over Form:

The accounting treatment and presentation of transactions and events in financial statements
should be governed by their substance and not merely by the legal form. Substance over form in
accounting refers to a concept that transactions recorded in the financial statements and
accompanying disclosures of a company must reflect their economic substance rather than their
legal form.
Whoever prepares the financial statements of a company needs to use their judgement to derive
the business sense from the transactions and events in order to present them in a manner that best
reflects their true essence.

At certain times the ‘legal form’' of a transaction may not provide its true image. Although the
legal form can be of importance, it may be disregarded in order to present more relevant
knowledge to the users of financial statements, who should not be misled.

A transaction is an instance of an event that could alter the financial status of a business entity. It
is usually a contract between a buyer and seller, which gives rise to an asset for one entity and/or
a liability for the other entity. Selling inventory, buying raw materials, indulging in legal
agreements and getting a bank loan are all examples of business transactions.

Despite accountants knowing they should not mislead readers of a company’s financial
statements, substance over form in accounting is in widespread use. For example If a small
adventure company in Cornwall buys a fleet of vans using a lease agreement from a bank, it will
pay some of the advance cost and the remaining sum for the vans over, say, a five-year period.
Now despite legally owning the vans from an ‘economic point of view’, the company will not be
recognised as the ‘legal owner’ until it pays the final instalment at the end of the fifth year.

c) Materiality:

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. The materiality principle
states that an accounting standard can be ignored if the net impact of doing so has such a small
impact on the financial statements that a reader of the financial statements would not be misled.

Generally, you do not have to implement the provisions of an accounting standard if an item is
immaterial. This definition does not provide definitive guidance in distinguishing material
information from immaterial information, so it is necessary to exercise judgment in deciding if a
transaction is material.

For example for presentation purposes an item representing at least 5% of total assets may be
separately disclosed in the balance sheet. However, much smaller items may be considered
material. For example, if a minor item would have changed a net profit to a net loss, that item
could be considered material, no matter how small it might be. Similarly, a transaction would be
considered material if its inclusion in the financial statements would change a ratio sufficiently to
bring an entity out of compliance with its lender covenants.

The materiality concept varies based on the size of the entity. A massive multi-national company
may consider a 1 billion shillings transaction to be immaterial in proportion to its total activity,
but 1 billion shillings could exceed the revenues of a small local firm, and so would be very
material for that smaller company.

The materiality principle is especially important when deciding whether a transaction should be
recorded as part of the closing process, since eliminating some transactions can significantly
reduce the amount of time required to issue financial statements. It is useful to discuss with the
company’s auditors what constitutes a material item, so that there will be no issues with these
items when the financial statements are audited.

5(b ) Explain the role of the above assumptions/concepts in financial accounting

practice

The accounting policies followed vary from organisation to organisation. It is important to

disclose significant accounting policies followed to make the financial statements
understandable. The disclosure is required by law in certain cases. In recent years, organisations
in India have adopted the practice of including a separate statement of accounting policies
followed in their annual reports to shareholders.

The purpose of this standard is to promote a better understanding of financial statements by

establishing the practice of disclosure of significant accounting policies followed and the manner
in which they are disclosed in the financial statements. Such disclosure would also facilitate a
more meaningful comparison between financial statements of different organisations.

Fundamental Accounting Assumptions

Financial Statements are prepared based on certain assumptions which are neither disclosed nor
required to be disclosed, so they are called Fundamental Accounting Assumptions, like Going
Concern, Consistency & Accrual.
As per AS 1 of the ICAI, certain fundamental accounting assumptions underlie the preparation
and presentation of financial statements. They are usually not specifically stated because their
acceptance and use are assumed. Disclosure is necessary only if they are not followed.

The following have generally been accepted as fundamental accounting assumptions:

i) Going Concern:

The going concern principle is the assumption that an entity will remain in business for the
foreseeable future. Conversely, this means the entity will not be forced to halt operations and
liquidate its assets in the near term at what may be very low fire-sale prices. By making this
assumption, the accountant is justified in deferring the recognition of certain expenses until a
later period, when the entity will presumably still be in business and using its assets in the most
effective manner possible.

An entity is assumed to be a going concern in the absence of significant information to the

contrary. An example of such contrary information is an entity’s inability to meet its obligations
as they come due without substantial asset sales or debt restructurings. If such were not the case,
an entity would essentially be acquiring assets with the intention of closing its operations and
reselling the assets to another party.

If the accountant believes that an entity may no longer be a going concern, then this brings up the
issue of whether its assets are impaired, which may call for the write-down of their carrying
amount to their liquidation value. Thus, the value of an entity that is assumed to be a going
concern is higher than its breakup value, since a going concern can potentially continue to earn
profits.

The going concern concept is not clearly defined anywhere in generally accepted accounting
principles, and so is subject to a considerable amount of interpretation regarding when an entity
should report it. However, generally accepted auditing standards (GAAS) do instruct an auditor
regarding the consideration of an entity’s ability to continue as a going concern..

For example, a business might have certain expenses that are paid off (or reduced) over several
time periods. If the business will stay operational in the foreseeable future, the company can
continue to recognize these long-term expenses over several time periods. Some red flags that a
business may no longer be a going concern are defaults on loans or a sequence of losses.

ii) Consistency:

It is assumed that accounting policies are consistently followed from one period to another. No
frequent changes are expected.

The consistency principle states that, once you adopt an accounting principle or method,
continue to follow it consistently in future accounting periods. Only change an accounting
principle or method if the new version in some way improves reported financial results. if such a
change is made, fully document its effects and include this documentation in the notes
accompanying the financial statements.

Auditors are especially concerned that their clients follow the consistency principle, so that the
results reported from period to period are comparable. This means that some audit activities will
include discussions of consistency issues with the management team. An auditor may refuse to
provide an opinion on a client's financial statements if there are clear and unwarranted violations
of the principle.

The consistency principle is most frequently ignored when the managers of a business are trying
to report more revenue or profits than would be allowed through a strict interpretation of the
accounting standards. A telling indicator of such a situation is when the underlying company
operational activity levels do not change, but profits suddenly increase.

Accrual:

Revenues and costs are recorded when they are earned or incurred (and not as money is received
or paid) in the periods to which they relate.

Under the ‘Accrual’ based accounting, transactions are recognised as soon as they occur,
whether or not cash or cash equivalent is actually received/ paid or not. Accrual basis ensures
better matching between revenue and cost. Profit/ loss calculated based on accruals, reflects
activities of the enterprise during an accounting period, rather than cash flows generated by it.

Accrual basis may be a more logical approach for profit determination vis-a-vis the cash basis of
accounting, however it exposes an enterprise to the risk of recognising an income before actual
receipt. The accrual basis can therefore overstate the divisible profits. Dividend decisions based
on such overstated/ unrealised profit may 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. Some
jurisdictions make 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.

Assumption relating to Accrual indicates that Financial Statement have been prepared based on
mercantile system, wherein the effect of transactions is recognised/ recorded when they are
entered into (and not when the cash is received or paid) and accordingly they get reported in the
financial statements of the relevant financial year to which they relate.

However, it may be noted that other accounting assumptions relating to business entity, money
measurement, matching, etc. are not fundamental accounting assumptions as per AS 1 of the
ICAI.