The consistency principle states that once a company adopts a certain accounting policy or method, it must be applied consistently in the future as well. This means that similar events and transactions over time will have the same accounting treatment.
It is highly discouraged that a company uses one accounting method in the current period, a different method in the next period and so on. The consistency principle requires that companies have a consistent set of policies and standards that are used while preparing the financial statements. This will ensure consistency of information given to users of the financial statements like creditors and investors.
The consistency principle, however, does not dictate that a company must use a certain accounting policy forever. If a company wishes to switch to another accounting method, it must provide the rationale to do so in terms of how the new methodology is better than the older one. For instance, a company might wish to switch from a straight-line method of depreciation to a double-declining method as it wants to realize more of the total depreciation expense in the earlier years than later.
If the company chooses to change an accounting policy or methodology, it will need to disclose this change in its financial statements including the financial impact of the change, date of change and the rationale behind this change. This will ensure that the company refrains from changing its accounting policy except when there are reasonable grounds for it to do so.
Importance of Consistency
Auditors are especially concerned that their clients are reporting the financial statements following the consistency principle. This makes the results from period to period comparable for the users of those financial statements including investors and creditors. Many auditors will have in-depth discussions with the client’s management team regarding consistency issues in the financial reports. An auditor might even refuse to provide its opinion on some client’s financial statements that are in clear violation of the consistency principle.
The consistency principle also prevents the management of a company from overstating its revenue and profit. If there was no consistency principle in place, the management could easily manipulate their financial statements each year using different accounting methodologies to overstate their performance. For instance, it might choose to switch from a double-declining balance method to a straight-line method of depreciation to overstate its profits in the initial years.
An indicator of a situation in which the company is not conforming to the consistency principle is when the company operational activity has not changed, but suddenly its profits increase. This should sound an alarm to the users of the financial statements for a deeper investigation. Upon investigation, if it is found that the company is violating the consistency principle without proper disclosers and rationale, then its financial statements would no longer be reliable or comparable.
Advantages of the Consistency Principle
Some of the advantages are given below:
By using the same accounting methods and policies, accounting business managers of a company will become familiar with the process. This will mean that they will only have to be trained initially after which they will be able to perform the financial reporting tasks consistently day in and day out.
If the accounting policies and methodologies employed by a company in preparing the financial statements were to change every period, this would significantly increase the cost of training and reduce the efficiency of the employee.
Consistency principle would ensure that employees are using the same accounting methodologies period to period and therefore they do not have to be retrained. Familiarization of the process will also increase the efficiency of the employee.
Most auditors will not provide their opinion on the reliability of the company’s financial statements if they find that the company has violated the consistency principle and have not provided enough disclosures or a good enough rationale to do so.
Comparable Financial Information
Using the consistency principle, a company will have a similar structure for its financial statements each period. This would make it easier for investors, creditors, managers, and other stakeholders to compare the financial and operational performance of a business over different years.
Consistency Principle Examples
Here are some examples in which the consistency principle can be followed or violated by a company.
Apple Computers has been using the First in First Out (FIFO) method for valuing its inventory. In the recent years, Apple Computers has become quite large and profitable. A consultant advises Apple to change its inventory valuation method to Last in First Out (LIFO) to minimize the taxable income. As per the consistency principle, the company can only do this if it has a justifiable reason and whether or not reducing the tax bill is justifiable is debatable.
Now consider that the same company, Apple Computers, plans on taking a loan from the bank and need to show good profits on its statements to do so. To overstate its profits for the period, it decides to change from LIFO back to FIFO. This is a clear violation of the consistency principle. Even if the first time around, Apple Computers was allowed to change its method (from FIFO to LIFO) and disclose it in the financial statements, it would not be able to justify another change in the inventory valuation methodology (back to FIFO) for this period as it cannot switch back and forth every year.
Horizon Real Estate purchases a software license for its listings every year. The software cost around $50,000. In the years in which Horizon Real Estate does not need a tax deduction, it capitalizes these licenses and amortizes them. In other years, in which it seeks a tax deduction, it expenses the whole amount. This clearly violates the consistency principle as Horizon Real Estate is switching back and forth with its accounting policies every year as the consistency principle states that different accounting treatments for the same or similar transactions can not be used in different periods.