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:
Familiarization
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.
Cost Efficiency
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.
Auditor Requirements
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.
Example 1
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.
Example 2
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.
Example 3
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.
FAQs
1. What does the Consistency Principle mean?
The consistency principle means that the company should use the same accounting policies and procedures in preparing its financial reports to ensure comparability of its financial information from year to year.
2. Why do we use the Consistency Principle?
The consistency principle is used to provide decision usefulness. It ensures that the financial information of a particular company can be compared with those of other companies and makes it easier for stakeholders such as investors, creditors, managers, and others to make decisions.
In addition, the consistency principle ensures that changes in policies are disclosed to the users of the financial information.
3. What is the importance of the Consistency Principle?
The importance of the consistency principle is in its ability to ensure comparability of financial reporting. If a company uses different accounting policies in recording the same or similar transactions, it would be difficult for investors and other interested parties to make reasonable comparisons.
4. What are the advantages and disadvantages of the Consistency Principle?
The advantages of the consistency principle are:
It enables comparability – It ensures that information from different companies can be compared as it allows for consistency and uniformity in financial reporting.
It facilitates decision making – The consistent application of accounting policies makes it easier for managers, investors, creditors and other stakeholders to make decisions without having to adjust their analysis for different accounting methods.
It enhances disclosure – The consistency principle ensures that any changes in policies are disclosed to the users of financial statements. This means that if a company decides to change certain accounting policies, it should disclose its reasons for doing so and explain why such policy should be followed from now on.
The disadvantage of the consistency principle is that it can lead to a distortion of the financial statements as it requires the company to use only one accounting policy for all types of transactions.
This can result in not recording some revenue and expenses that should be recorded and disclosing relevant information that should be kept confidential and unknown to its competitors and other interested parties.
5. What are some examples of the consistency principle?
For example, changes in the company's inventory valuation method should not be made without a valid reason. This way, it would be possible to compare the financial reporting of different years and see whether it is increasing its profits by changing certain policies.
Another example is that depreciation must be calculated using the same depreciation method every year. It would be wrong for a company to change its depreciation method from one year to the next, because this would distort the results of a particular fiscal year.
