Consistency Concept has fundamental importance in the preparation of financial statements. According to this, an entity must continue to use the same accounting policies from one period to another and so on. This ensures consistency of accounting policies and makes it easy for the users of the financial statements to compare results over the periods.
If the entity is changing accounting policies so forth, then there will be a problem of comparability due to inconsistency. A change in accounting policy is admissible if the change in accounting policy is necessary for better true and fair presentation. The entity has to disclose in the notes, the date of change, justification of doing so and the effect of such a change.
Example # 1
ABC Company is following weighted average cost method for valuation of inventories. On the next year, it has changed the inventory valuation method to FIFO (First in first out) without any justification. Such change is against the consistency principle of accounting and is not allowed, unless and until ABC can explain the reasons why such a change is necessary for true and fair view of the financial information.
Example # 2
HK Business solution is engaged in biscuits manufacturing operations since 15 years. It is regarded as one of the main supplier to the hotel industry of African countries. Following transactions and information are available for HK Business solution over which the statutory auditors are concerned due to inconsistency. These are:
- The HK was initially using straight line method of depreciating the assets. Now, it has switched to write down value (WDV) method without any reason and need.
- The HK was valuing its inventories using weighted average method. Now, in this accounting period, it has adopted FIFO (First in first out) method.
- The HK was capitalizing its borrowing cost. But now management has decided it to be amortized over 10 years commencing from last 03 years.
Required
Explain to the Board of Director as how to treat above information/ transactions.
Solution
- Initially, HK was using straight line method of depreciation for depreciating the fixed assets of the company. As written above, the change to WDV method is without any reason and this change is just for the sake of change. Under these circumstances, external auditor has right over concerns over the change in accounting policy of depreciating the asset because the change in accounting policies could bring inconsistency factor.
- It is brought into your kind notice that weighted average and FIFO (First in first out) methods are both allowable methods of valuing the inventory. It is the choice of management to use the method which it thinks will present the financial information correctly. But, in order to maintain consistency, efforts should be done to follow one accounting policy from one accounting period to the other.
- In order to expense out the borrowing cost, it should be kept in mind that this could bring comparability and inconsistency in the financial statements. HK has to look out other competitors’ method of amortizing the borrowing cost. If they are recording borrowing cost as expense at the time it is incurred, then HK can also do so in order to make their accounting records comparable with industry competitor. Otherwise, it would be a serious breach of consistency.
In short, while HK is planning to make changes in accounting policies, it should keep comparability factor in mind to ensure that financial statements give a true and fair view of the state of the company’s affairs. While making changes in accounting policies, following should be disclosed:
- Nature of the change in accounting policy,
- Complete reasons should be disclosed to support the action taken for change in accounting policy,
- Change in accounting policy should be retrospective,
- However, if retrospective effect is not change, the prospective change in accounting policy is allowed only in case when you have sufficient reasons to prove your point of view.