Consistency concept of accounting implies that entity should continue to apply selected accounting policies and estimation process from one accounting period to the next to record similar events, situations and transactions unless:
- new technique, policy or estimate selected, in the opinion of management, can better help in preparing relevant and reliable financial statements that present true and fair view of the business
- older technique has been discarded by the applicable accounting framework
Accounting frameworks around the world prohibit frequent change in accounting policies. This greatly affects comparability of financial statements and hence users’ understanding of the entity and its operations i.e. understandability.
However, entity is not barred from changing accounting policies if situation arises where existing policy or estimate no longer gives faithful representation of the transaction or event. Accounting frameworks leave it on management to judge and decide the matter. If management is of the opinion that there are reasonably logical grounds to alter the technique and they are confident that new accounting technique is better in presenting relevant and reliable financial statements then they can proceed with alteration and change in accounting policy must be disclosed in the notes to financial statements.
If there is any modification in accounting policy as compared to previous accounting period entity must disclose:
- nature of change
- reason that compelled management for change and how the new technique can improve financial statements’ relevance and reliability.
- effect the change has on relevant line items in the financial statements
If there is any modification in estimates then entity must disclose the nature and the amount of effect the change in estimate has related to current and future periods
Examples
Cost flow assumption
Whatever cost assumption entity selects, it must use it consistently from period to period. Switching the evaluation methods from FIFO to LIFO to AVCO frequently will significantly affect net profit calculation of the entity and will render financial statements of the two periods incomparable. Not only income, it will affect current assets as well.
However, if entity feels the current cost flow assumption is not representative of the price trend or complying with the applicable framework then the change should be disclosed in the notes to the financial statements and how the change has affected profit calculation and assets total.
For example changing from FIFO to LIFO in inflationary economy will suddenly cause profits to fall and cost of sales to increase and how current and quick ratio calculations are affected before and after the change.
Depreciation method
Entities are required to practice consistency in applying depreciation methods from period to period. If entity has selected straight line method of depreciation then it should continue to use to it for future periods unless valid reasons compel entity to alter the estimation technique.
For example if entity is using straight-line method assuming that utility in asset is consumed on equal basis every time then it should continue using this method. However, if use or process changes in a manner that benefits generated from the asset and its efficiency is declining from one period to another then entity should switch to declining balance method.