EPFO APFC 2023 General Studies · Question 107 of 120

Correct — A, (a) conservatism. Conservatism, which Indian accounting standards call prudence, is the convention that losses which are foreseeable must be provided for as soon as they are foreseen, while gains are not recognised until they are realised. The traditional formulation is blunt: anticipate no profit, but provide for all possible losses. Every element of the stem is that rule in action. The firm holds long-term investments in shares; the market value of those shares may fall below what was paid for them; a fall is a loss that has not yet been crystallised by any sale; and the firm nevertheless creates a provision against it, charging the anticipated loss to the profit and loss account now rather than waiting for the shares to be sold. No corresponding entry would be made if the shares had risen in value, because an unrealised gain is not recognised under this convention. That asymmetry — losses early, gains late — is the signature of prudence and distinguishes it from every other option offered. The rule as it applies to investments is set out in Accounting Standard 13, Accounting for Investments. Long-term investments are ordinarily carried in the books at cost, and the carrying amount is reduced only when there is a decline in value that is other than temporary; the reduction is charged to the profit and loss account. Current investments, by contrast, are carried at the lower of cost and fair value, so a fall is recognised immediately whether it looks temporary or not. The wording of the standard matters for accuracy: a mere fluctuation in the market price of a long-term holding, expected to reverse, does not by itself require a provision, and the standard requires the decline to be other than temporary. What the standard does not do is alter the reason a provision is created when one is required. That reason is conservatism, and it is the same reason inventory is valued at the lower of cost and net realisable value, the same reason a provision for doubtful debts is raised against receivables that have not yet gone bad, and the same reason a contingent liability that is probable and measurable is provided for while a contingent asset is not. The convention exists to keep the accounts from overstating profits and assets, on the view that an over-optimistic balance sheet does more damage to creditors, lenders and shareholders than an over-cautious one.

• (b)full disclosure — Full disclosure requires that financial statements and their notes reveal every piece of information material enough to affect the judgement of a person relying on them — the accounting policies followed, the basis of valuation, contingent liabilities, related-party transactions, events after the balance sheet date and so on. It is a convention about telling, not about measuring. Once the firm has decided to create a provision against a fall in the value of its investments, full disclosure governs what it must then say about that provision: the policy adopted, the amount set aside and the basis on which it was computed, all of which appear in the notes and in the statement of accounting policies required by Accounting Standard 1. But full disclosure never tells a firm to recognise an anticipated loss in the first place. Strip the provision out and disclose the fall in value in a note instead, and full disclosure is satisfied while conservatism is not — which is the cleanest way to see that this option answers a different question.
• (c)materiality — Materiality is the convention that an item need be recorded, disclosed or treated separately only when knowledge of it could influence the decision of a user of the accounts; immaterial items may be dealt with in whatever way is most convenient. It is one of the three major considerations governing the selection and application of accounting policies under Accounting Standard 1, alongside prudence and substance over form, which is what makes it a plausible answer here. What materiality decides, though, is a threshold: whether a fall in the value of the investments is large enough to be worth recognising and reporting at all. It has nothing to say about the direction of the treatment. If materiality were the governing convention, a firm would be equally obliged to recognise a material rise in the value of the shares, which no set of accounts prepared on the historical cost basis does. The asymmetry between losses and gains comes from prudence alone.
• (d)consistency — Consistency requires that a firm apply the same accounting policies from one period to the next, so that its results and position can be compared across years, and that it change a policy only for good reason and with disclosure of the change and its effect. Under Accounting Standard 1 it is one of the three fundamental accounting assumptions, along with going concern and accrual — not one of the three major considerations in selecting a policy, a distinction this paper tests directly elsewhere. In relation to the provision described here, consistency has a real but secondary role: having chosen to provide against declines in investment values on a particular basis, the firm must go on doing so on the same basis in later years rather than providing in bad years and omitting to provide in good ones. That is a rule about repeating a treatment. It cannot explain why the treatment exists, and a firm that had never created such a provision would be perfectly consistent.

Accounting conventions are the settled customs that govern how transactions are measured and reported, and four of them recur in every syllabus: conservatism or prudence, consistency, full disclosure and materiality. Conservatism directs that all anticipated losses be provided for and no anticipated gains be recognised, so that in conditions of uncertainty assets and income are not overstated and liabilities and expenses are not understated. Its everyday applications are the ones to hold ready: inventory valued at the lower of cost and net realisable value, a provision for doubtful debts, a provision for discount on debtors, provision for a decline in the value of investments, and the recognition of a probable loss on a contingency while a contingent gain is left out. The Indian framework builds these into rules. Accounting Standard 1, on disclosure of accounting policies, names three fundamental accounting assumptions — going concern, consistency and accrual — which are presumed to have been followed unless the contrary is disclosed, and three major considerations governing the selection and application of accounting policies, which are prudence, substance over form and materiality. Accounting Standard 13, on investments, classifies holdings as current or long-term: current investments are carried at the lower of cost and fair value, while long-term investments are carried at cost with a reduction made for any decline that is other than temporary. Entities that report under the Ind AS framework instead apply Ind AS 109, which measures most investments at fair value, but the older classification is what an accountancy paper of this kind examines.

An EPFO paper tests accounting conventions because a provident fund organisation both keeps accounts and reads them: an Assistant Provident Fund Commissioner examines employers' books to establish liability for contributions and damages, and has to know when a figure in those books represents a real outflow and when it represents a management estimate. A provision is exactly such an estimate, and knowing which convention licenses it is the difference between reading a balance sheet and merely looking at one. The item is constructed so that all four options are genuine conventions and three of them touch the transaction described in some way — full disclosure governs what is said about the provision, materiality governs whether it is large enough to matter, consistency governs whether the same treatment is repeated next year — while only one explains why the provision comes into existence at all. Reading the stem's verb closely is what separates them: it asks what the creation of the provision is based on, not what must then be disclosed about it. Two features of the printing are worth noting for what they signal. The stem is an incomplete sentence finished by the options and ends without a question mark, which is this booklet's habit on several accountancy and current-affairs items; and the options are printed in lower case as single words. Neither is a misprint. This block of the paper — accountancy, auditing and insurance — runs to about fifteen questions across the booklet, so the conventions are worth learning as a set rather than one at a time.

• Conservatism, called prudence in the standards, requires that all foreseeable losses be provided for while gains are recognised only when realised. The classical statement is 'anticipate no profit, provide for all possible losses', and the asymmetry between the treatment of losses and gains is what identifies the convention in any exam stem.
• Standard applications of prudence: inventory at the lower of cost and net realisable value, provision for doubtful debts, provision for discount on debtors, provision for a decline in the value of investments, and recognition of a probable and measurable contingent loss while a contingent gain is not recognised at all.
• Accounting Standard 13, Accounting for Investments, carries long-term investments at cost and requires the carrying amount to be reduced only where a decline in value is other than temporary; current investments are carried at the lower of cost and fair value, so a decline in them is recognised at once whether temporary or not.
• Accounting Standard 1 names three fundamental accounting assumptions — going concern, consistency and accrual — which are presumed followed unless the contrary is disclosed, and three major considerations in the selection and application of accounting policies — prudence, substance over form and materiality. Consistency belongs to the first list and not the second.
• The four conventions in one line each: conservatism decides the direction of an estimate; consistency requires the same policy across periods; full disclosure requires every material fact to be revealed in the statements or notes; materiality sets the threshold below which an item need not be separately recorded or disclosed.

• Choosing full disclosure because a provision has to be disclosed. Disclosure governs what is said about a measurement that has already been decided on; it never requires an anticipated loss to be recognised, and a firm that disclosed the fall in a note without providing for it would satisfy disclosure and breach prudence.
• Confusing materiality with prudence because Accounting Standard 1 lists them side by side. Materiality sets a threshold of significance and applies equally to gains and losses; prudence sets a direction, and it is the only convention that treats an unrealised loss differently from an unrealised gain.
• Treating consistency as a major consideration in selecting an accounting policy. It is a fundamental accounting assumption under Accounting Standard 1, alongside going concern and accrual, and this paper tests that boundary directly in another accountancy item.
• Assuming every fall in the market price of a long-term investment must be provided for. Accounting Standard 13 requires a reduction in the carrying amount only where the decline is other than temporary; the treatment for current investments, at the lower of cost and fair value, is the stricter one.

Convention and concept questions are a fixture of the accountancy block in these papers, and they come in three shapes. The first, used here, describes a transaction or a valuation practice and asks which convention it rests on — inventory at the lower of cost or market, a provision for doubtful debts, writing off a small asset immediately, valuing assets on a going concern basis rather than at break-up value. The second names a list and asks which item does or does not belong to it, which is where the Accounting Standard 1 division between fundamental assumptions and major considerations earns its marks. The third gives a definition and asks for the name. All three are answerable from a single page of well-made notes: one line of definition for each concept and convention, plus two standard applications for each. Because the options are almost always four genuine conventions rather than three obvious fillers, the discrimination lies in matching the exact verb of the stem — measured, disclosed, recorded, compared — to the convention that governs that particular act.

No directly related past PYQ was found.

• practice — not a real PYQ

  Closing inventory is valued at cost or net realisable value, whichever is lower. This practice is an application of which one of the following accounting conventions?

  • (a)Consistency
  • (b)Prudence
  • (c)Materiality
  • (d)Full disclosure

  Answer(b) Prudence — valuing stock at the lower of the two figures writes down a loss that has not yet been realised by any sale, while a rise in net realisable value above cost is ignored until the goods are sold. That asymmetric treatment of unrealised losses and unrealised gains is the definition of prudence, or conservatism. Consistency would only require the same rule to be applied every year, and materiality would only decide whether the difference is large enough to matter.

• practice — not a real PYQ

  Under Accounting Standard 13, the carrying amount of a long-term investment is reduced to recognise a fall in its value in which one of the following situations?

  • (a)In every case where the market value falls below cost, however briefly
  • (b)Only where the decline in value is other than temporary
  • (c)Only where the investment is sold during the accounting period
  • (d)Only where the fall exceeds one-tenth of the original cost

  Answer(b) Only where the decline in value is other than temporary — long-term investments are ordinarily carried at cost under Accounting Standard 13, and the standard requires the carrying amount to be reduced, with the reduction charged to the profit and loss account, when a decline is other than temporary. The stricter treatment applies to current investments, which are carried at the lower of cost and fair value, so that any fall is recognised at once.