Advanced Accounting · AS 1 Disclosure of Accounting Policies

Selection of Accounting Policies under AS 1: Prudence, Substance over Form, Materiality

Updated 4 October 2026 · Fact-checked

AS 1 says accounting policies must be chosen and applied so that financial statements give a true and fair view. The three main considerations are prudence (provide for known liabilities and expected losses, do not anticipate profits), substance over form (record the economic reality) and materiality (disclose items that influence decisions).

Understand Selection and Consideration of Accounting Policies: Prudence, Substance over Form, Materiality

An accounting policy is a specific principle, base or method an enterprise adopts to prepare and present its financial statements. Where the law allows more than one treatment, management must choose. AS 1 tells you how to choose: the aim is always a true and fair view of the state of affairs and the profit or loss.

AS 1 names three major considerations. They guide the choice of a policy and also its application.

Prudence deals with uncertainty. Many outcomes at the balance sheet date are not certain. Prudence says you should provide for all known liabilities and expected losses, even if the amount cannot be determined with certainty and is only a best estimate. You should not recognise anticipated profits. It is not a licence to create hidden reserves or to understate profits on purpose. That would defeat a true and fair view. For the detailed recognition rules on provisions and contingencies, the specific standard is AS 29.

Substance over form says a transaction should be accounted for by its economic reality, not only its legal form. The classic example is a finance lease. Legally the lessor owns the asset. In substance the lessee enjoys the risks and rewards, so the lessee shows the asset and the liability. Another example is a sale with a buy-back, where the seller may keep the risks and rewards. AS 1 gives only the principle. The conclusion in each case depends on the facts.

Materiality says financial statements should disclose all items that are material enough to affect decisions of users, or that influence how they evaluate the entity. An item is material if its omission or misstatement could change a user's decision. Materiality depends on the size or nature of the item, or both, as judged in the particular circumstances. It is not fixed by a percentage.

The three work together. Prudence guards against optimism, substance keeps the picture real, and materiality keeps the statements useful and not cluttered. Management chooses and applies policies using these, then discloses the significant policies so users can understand the accounts.

Key rules to remember

Objective of selecting policies: Policies chosen and applied → true and fair view; Use this as the closing line in every theory answer.
Prudence: Provide for known liabilities and expected losses, even if the amount is only an estimate; do not recognise anticipated profits; Applies to uncertain items. It does not permit deliberate understatement of profit or overstatement of provisions.
Substance over form: Account by economic reality, not by legal form alone; Typical examples: finance lease, sale with buy-back, transactions with side arrangements. The conclusion depends on the facts.
Materiality: Disclose items whose omission or misstatement could influence users' decisions; Depends on the size or nature of the item, or both, in the circumstances. No fixed percentage is laid down in AS 1.
Fundamental assumptions: Going concern, consistency, accrual; If followed, no separate disclosure is needed. If not followed, the fact must be disclosed.

How to solve Selection and Consideration of Accounting Policies: Prudence, Substance over Form, Materiality questions

Use this method for a case-based or theory question on selecting policies.

1Identify what the question tests: prudence, substance over form, materiality, or a mix.
2State the relevant AS 1 consideration in one line, in your own words.
3Pick out the facts: is there uncertainty, a legal form that differs from reality, or an item of significant size or nature?
4Apply the consideration to the facts and decide the treatment (provide, do not recognise, show as asset or liability, disclose or omit).
5Check you have not over-applied prudence by creating hidden reserves or under-valuing on purpose.
6Write the conclusion and link it to a true and fair view, noting any disclosure needed.

Quickest way: Three-word trigger method

When to use it: Use it for MCQs and for short theory or case-based written answers when time is tight.

Spot the trigger word. Uncertain loss or gain means prudence. Legal ownership versus actual benefits means substance. Small or large item, or disclosure, means materiality.
For MCQs, eliminate options that recognise an expected profit or ignore a known expected loss, since those break prudence.
Eliminate options that follow legal form when the facts show risks and rewards with another party.
For written answers use a three-line format: Provision (AS 1 principle), Facts (apply), Conclusion (treatment and true and fair view). This earns step marks.
Always end with the effect on the true and fair view.

Common mistakes in Selection and Consideration of Accounting Policies: Prudence, Substance over Form, Materiality

Treating prudence as permission to understate profits or create secret reserves.
Students remember 'be cautious' and stop there.
Fix: Say prudence covers real uncertainty only. Deliberate understatement conflicts with a true and fair view.
Recognising an expected gain because it looks certain.
Confusing a realised gain with an anticipated one.
Fix: Recognise gains only when realised or when the recognition criteria are met. Provide for expected losses even when the amount is only an estimate.
Deciding ownership by legal title in lease or buy-back cases.
Students link the asset to the legal owner by habit.
Fix: Ask who bears the risks and rewards on all the facts. Account accordingly, as the substance prevails.
Using a fixed percentage, such as 5% of profit, as the test for materiality.
Rules of thumb from audit are carried over.
Fix: State that materiality depends on the size or nature of the item, or both, judged in the circumstances. AS 1 gives no fixed limit.
Mixing up considerations with fundamental assumptions.
Both appear in the same standard.
Fix: Prudence, substance and materiality are considerations for choosing policies. Going concern, consistency and accrual are fundamental assumptions.

Worked examples

Example 1

Alpha Ltd sold machinery to Beta Ltd for ₹10,00,000 and, under a side agreement, will buy it back after one year at a fixed price of ₹11,00,000. Alpha continues to use the machine. Explain how Alpha should treat the transaction under AS 1 and why.

Show the solution

Legal form: ownership has passed to Beta, so the form looks like a sale.
Substance: Alpha will buy the machine back at a fixed price and keeps using it. On these facts, the fixed repurchase price shows that the risks and rewards stay with Alpha.
AS 1 gives only the principle that substance prevails over form. It does not prescribe buy-back accounting, so the conclusion depends on the facts. Here all the facts point the same way.
So Alpha should not record a sale or profit. The ₹10,00,000 received is treated as a financing arrangement, that is, a borrowing, and the machine stays in Alpha's books.
The excess of ₹1,00,000 (₹11,00,000 − ₹10,00,000) is a financing cost, accounted for over the year.

Answer: On these facts, Alpha should treat it as a financing arrangement: a borrowing of ₹10,00,000 secured on the machine, not a sale. The machine stays as an asset and ₹1,00,000 is a finance charge over the year. AS 1 supplies the substance over form principle, and the facts support this conclusion and a true and fair view.

Example 2

At the year end, a company has a claim against it for damages. Legal advisers say it is likely that the company will lose and pay about ₹4,00,000. The company also expects to win a separate claim of ₹6,00,000 from a customer, but the court has not yet decided. How does prudence apply to the two items?

Show the solution

Identify the two uncertain items: an expected loss and a possible gain.
Prudence requires providing for known liabilities and expected losses, even if the amount is only an estimate. So the loss of about ₹4,00,000 is provided for in the current year. AS 29 is the specific standard for detailed provision and contingency rules.
Prudence does not allow recognising an anticipated profit. The ₹6,00,000 claim is not yet realised, so it is not recognised as income.
The gain is not credited to profit and loss. Any disclosure is considered separately under the specific standard.
Net effect on profit: only the ₹4,00,000 charge is booked.

Answer: Provide ₹4,00,000 for the expected loss and do not recognise the ₹6,00,000 claim until it is realised. This is prudence applied to give a true and fair view.

Exam tips

Write the definition of each consideration in one sentence, then apply it. Pure definitions without application score poorly.
In case studies, always name the principle by its AS 1 term. Examiners look for the term.
For materiality, say it depends on the size or nature of the item, or both, judged in the circumstances. Do not quote a fixed percentage.
In MCQs, any option that books an unrealised gain or ignores a known expected loss is usually wrong.
Finish theory answers with the effect on the true and fair view.

Practice questions from AS 1 Disclosure of Accounting Policies

Selection and Consideration of Accounting Policies: Prudence, Substance over Form, Materiality in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

CMA IntermediateSelection and Consideration of Accounting Policies

Selection and Consideration of Accounting Policies: Prudence, Substance over Form, Materiality: frequently asked questions

What are the three major considerations in selecting accounting policies under AS 1?

They are prudence, substance over form and materiality. Management applies them so that the financial statements give a true and fair view.

Does AS 1 give a percentage limit for materiality?

No. Materiality depends on the size or nature of an item, or both, judged in the circumstances. An item is material if its omission or misstatement could influence users' decisions.

Is a finance lease an example of substance over form?

Yes. The lessor holds legal title, but the lessee bears the risks and rewards. So the lessee records the asset and liability, following the substance.

Can prudence be used to create hidden reserves?

No. Prudence deals with genuine uncertainty by providing for known liabilities and expected losses. Deliberately understating profit or overstating provisions goes against a true and fair view.