Financial Accounting · Disclosure of Accounting Policies (AS 1)

Selection and Consideration of Accounting Policies under AS 1

Updated 10 October 2026 · Fact-checked

AS 1 says that when you select and apply accounting policies, the financial statements should give a true and fair view. To get there, management considers three things: prudence, substance over form and materiality. You choose the policy that reflects the real position, not just the legal wrapper, and you disclose what matters.

Understand Selection and Consideration of Accounting Policies

An accounting policy is a specific principle, base, convention, rule or practice a business adopts to prepare and present its financial statements. Two businesses can face the same transaction and still choose different policies, for example stock valuation or depreciation method. So AS 1 gives guidance on how to choose.

The aim is simple. The policies you select and apply should lead to financial statements that show a true and fair view of the state of affairs and the profit or loss. AS 1 names three major considerations for this: prudence, substance over form and materiality.

Prudence deals with uncertainty. Future outcomes are not known, so you do not overstate profit or assets. You provide for all known losses and liabilities, even if the amount is an estimate. You do not recognise expected profits until they are realised. Prudence does not allow you to create hidden reserves or deliberately understate profit.

Substance over form means you record a transaction by its economic reality, not only its legal form. If goods are sold with a buy-back arrangement that makes it a financing deal, the substance is a loan, not a sale. Think of the question: who really bears the risks and enjoys the rewards?

Materiality means you disclose all items that are material enough to affect decisions of users of the statements. An item is material if omitting or misstating it could influence a reader's decision. It depends on size and nature, so there is no fixed percentage. A small item can be material by nature, and a large item can be immaterial in a very big business.

Key rules to remember

Objective of selecting policies: Policies selected and applied → true and fair view of the state of affairs and of profit or loss; Every consideration is a tool to reach this objective. Use it as your closing line in answers.
Three major considerations (AS 1): Prudence + Substance over form + Materiality; Name all three and define each in one line. Do not mix them up with the fundamental assumptions (going concern, consistency, accrual).
Prudence rule: Provide for all known losses and liabilities (even if estimated); do not anticipate profits; Prudence does not permit deliberate understatement of income or assets.
Substance over form rule: Account by economic reality, not legal form; Test: who bears the risks and rewards of ownership?
Materiality rule: Disclose items whose omission or misstatement could influence users' decisions; Judged by size and nature of the item. No fixed percentage cut-off.

How to solve Selection and Consideration of Accounting Policies questions

Use this method for definitions, short notes, and case-based questions on selecting accounting policies.

1Read the question and decide what is asked: a definition, a comparison, or a case where you must choose a treatment.
2State the objective first: policies must give a true and fair view of the state of affairs and profit or loss.
3Name the relevant consideration (prudence, substance over form or materiality) and define it in one sentence.
4For a case, identify the facts: is there uncertainty about gain or loss, a gap between legal form and economic reality, or an item whose size or nature matters?
5Apply the consideration to the facts and state the treatment, for example provide for the loss, treat as financing, or disclose separately.
6Give the figure or entry if the question asks for it, with a one-line reason.
7Close with a conclusion linking the treatment to a true and fair view.

Quickest way: Three-question test for any policy case

When to use it: Use it when a short case gives you a transaction and asks which consideration applies or what the treatment should be.

Ask: Is something uncertain? If yes, think prudence: provide for losses, do not book expected gains.
Ask: Does the legal paper differ from the real deal? If yes, think substance over form: record by who holds risks and rewards.
Ask: Would leaving this out or mis-stating it change a reader's decision? If yes, think materiality: disclose it.
Write the answer as: consideration, one-line reason, treatment.

Common mistakes in Selection and Consideration of Accounting Policies

Treating prudence as permission to understate profit or create secret reserves.
Students remember 'be conservative' and stretch it too far.
Fix: Write that prudence means providing for known losses and not anticipating profits. It does not allow deliberate understatement.
Defining substance over form as 'ignore the legal form completely'.
The phrase sounds like form does not matter.
Fix: Say that economic reality governs the accounting treatment, and legal form is still considered but does not override the substance.
Giving a fixed percentage as the materiality limit.
Students borrow rules of thumb from audit or practice.
Fix: State that materiality depends on size and nature and on the decisions of users. Do not quote a fixed cut-off.
Mixing the three considerations with the fundamental accounting assumptions.
Both are in AS 1 and both sound like principles.
Fix: Keep two lists: assumptions (going concern, consistency, accrual) and considerations for selecting policies (prudence, substance over form, materiality).
Writing a theory answer without applying it to the facts of the case.
Students recall definitions but skip the link to the transaction.
Fix: After the definition, add a sentence that names the specific fact from the question and states the resulting treatment.

Worked examples

Example 1

Ravi Traders sold machinery to Finserve Ltd for ₹10,00,000 and, in the same agreement, agreed to buy it back after one year for ₹11,00,000. Ravi Traders continues to use the machinery. How should Ravi Traders treat the transaction as per the consideration of substance over form?

Show the solution

Identify the facts: legal form is a sale, but the seller must buy the asset back at a fixed higher price and continues to use it.
Ask who holds the risks and rewards: Ravi Traders still holds them, since the buy-back price is fixed and it uses the machine.
Conclude the substance: the deal is a secured borrowing, not a genuine sale.
Treatment: do not record sales revenue or derecognise the machinery. Show ₹10,00,000 received as a liability (loan).
The extra ₹1,00,000 (₹11,00,000 − ₹10,00,000) is the cost of financing and is treated as finance cost over the year.
Link to the objective: this gives a true and fair view by not inflating sales and profit.

Answer: Treat it as a loan of ₹10,00,000 and keep the machinery in the books. The ₹1,00,000 difference is finance cost, not a profit on sale.

Example 2

At the year-end, Anaya Enterprises holds stock that cost ₹4,50,000. Its net realisable value is ₹4,00,000. A customer owing ₹60,000 has been declared insolvent and nothing is expected to be recovered. Another debtor is expected to pay in full but the firm hopes to earn ₹25,000 extra from a pending contract that is not yet signed. Apply prudence.

Show the solution

Stock: the cost is higher than net realisable value, so a loss is expected. Value the stock at the lower figure of ₹4,00,000.
Loss on stock to be recognised is ₹4,50,000 − ₹4,00,000 = ₹50,000.
Insolvent customer: the loss is known, so write off the entire ₹60,000 as bad debt.
Pending contract: the profit of ₹25,000 is not yet realised, so do not recognise it.
Total charge to profit and loss for the two losses is ₹50,000 + ₹60,000 = ₹1,10,000.
Conclude: prudence means provide for known losses and do not anticipate gains.

Answer: Value stock at ₹4,00,000, write off ₹60,000 as bad debt, total losses ₹1,10,000, and ignore the unsigned contract's ₹25,000 expected profit.

Exam tips

Write all three considerations by name in any 'AS 1 selection of policies' answer, each with a one-line definition.
In case questions, always link the treatment to a true and fair view in the last line. It earns the concluding mark.
Do not quote a fixed percentage for materiality. Say it depends on size and nature of the item.
For MCQs, look for key phrases: 'economic reality' points to substance over form, 'anticipate no profit, provide for all losses' to prudence, 'influence decisions of users' to materiality.
When a question asks for the treatment, include the figure or entry as well as the theory, since step marks are given for both.

Practice questions from Disclosure of Accounting Policies (AS 1)

Selection and Consideration of Accounting Policies in other exams

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

Selection and Consideration of Accounting Policies: frequently asked questions

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

AS 1 names three: prudence, substance over form and materiality. They guide management so that the policies chosen give a true and fair view. Learn each with a one-line definition and a small example.

What is the difference between prudence and substance over form?

Prudence deals with uncertainty and asks you to provide for known losses without anticipating profits. Substance over form deals with the nature of a transaction and asks you to record its economic reality over its legal shape. One is about caution, the other about reality.

Is there a fixed percentage limit for materiality in AS 1?

No. Materiality depends on the size and nature of the item and whether it could affect users' decisions. Do not write a fixed percentage in your answer.

Can you give an example of substance over form?

A sale of an asset with a fixed-price buy-back, where the seller keeps using it, is a common example. The legal form is a sale, but the substance is a loan secured on the asset. So you record a liability, not a sale.