Your financial statements are key to showing the state and solvency of your business. In the event that you want to take out a loan, go public with your company, or look for investors so you can expand, your financial statements and accounting needs to be reviewed. This gives lenders and investors a clear, accurate look at your current numbers so they can determine if your business is “worth the risk,” so to speak.
In some cases, a lender or investor will request that the client’s financial statements are audited to look for internal controls and determine if the financial statements are represented fairly and compiled in accordance with generally accepted accounting principles (GAAP). One of the things auditors look for is the Consistency Principle. To help you learn more about this concept and adopt it in your accounting practices, our CPAs are breaking down what it is, the advantages to using it, and even sharing some examples of violations.
Defining the Consistency Principle
Simply put, the Consistency Principle means that once your organization, or, more specifically, your bookkeeper or accounting department, adopts an accounting principle or method of documenting and reporting information, that method has to be used consistently moving forward. This applies to the line items on your financial statements, including things like:
- Cash flow statements
- Balance sheets
- Profit & loss statements
- Accounts payable/accounts receivable reports
Relying on a consistent accounting method ensures that statements and information will be comparable, and it will be easier to see trends and extract accurate information.
Challenges of the Consistency Principle
In theory, maintaining consistent accounting and bookkeeping methods shouldn’t be a problem. However, the disconnect is most likely to happen in two scenarios:
High Turnover or Relying on Different Bookkeepers
When you have several different people recording data, compiling reports, and performing other financial documentation, the Consistency Principle is seldom followed. You need a set method in place internally or to rely on an accounting firm who follows consistent policies and procedures in order to ensure GAAP is followed.
Intentionally Shifting Reporting to Show an Advantage
In some cases, organizations will change how they report information in order to take advantage of loopholes or manipulate how data looks.
Examples of Consistency in Accounting Methods
To get a look at the Consistency Principle, let’s take a look at two main methods of reporting account inventory and the cost of goods sold.
First-in, First-out (FIFO)
This is a cost flow assumption in which oldest costs of inventory (which are often the lowest) will be the first removed from a balance sheet account inventory, and the most recent costs (which are often the highest) will remain in inventory and reported on the balance sheet. For example, a company had 30 units of Product A on hand at $10 per unit in January, then bought an additional 50 units at $15 per unit. When they sell, 40 units, they will record 30 sales at $10 and 10 sales at $15, leaving a cost of inventory of 40 units at $15. This method often shows a higher net income.
Last-in, First-out (LIFO)
This is a cost flow assumption in which the most recent costs of products are the first to come out of inventory so the oldest costs stay in. For example, a company had 30 units of Product A on hand at $10 per unit in January, then bought an additional 50 units at $15 per unit. When they sell, 40 units, they will record 40 sales at $15, leaving a cost of inventory of 10 units at $15 and 30 at $10. This method often shows a lower net income which can be beneficial to minimize taxes.
A business can choose either of these methods, and can even make a one-time change between the two. However, a business can’t report based on LIFO one year to pay less in taxes, then the next year shift to FIFO to show a higher net income and be more attractive to investors, then go back to LIFO the following. Doing so makes it impossible to analyze trends in financial statements and provide a proper audit.
Advantages of the Consistency Principle
As a business owner, following the Consistency Principle offers several specific advantages:
- Ease of auditing by a third party. In fact, auditors will often refuse to provide an analysis if the Consistency Principle isn’t followed.
- Saves time. Instead of trying to learn and train in different ways, you and your accounting team know one, consistent way to report data.
- Track trends. You need to be able to spot trends in your finances, and if there’s no set way of reporting and recording them, you’ll miss important information.
Schedule a Business Accounting Consultation
Our CPAs offer the services you need to ensure consistent accounting practices in your business. From bookkeeping that is highly accurate and can work with you on a monthly, quarterly, or annual basis to financial statement preparation, we’re here to support you however we can. If you do need a third party audit for your statement, we can provide those services too. With our range of comprehensive accounting services for businesses, you can get customized accounting for your organization. We serve Raleigh, Wake Forest, Wilson, Garner, Cary, and surrounding communities. Schedule a consultation today by calling us at (919) 872-0866 or filling out the form below to get started.