Consistency is a critical principle in accounting that ensures that financial information is presented in a uniform and comparable manner over time and across different entities. It allows users of financial statements to make meaningful comparisons, assess the financial performance and position of an entity, and make informed decisions. However, accounting standards may provide alternative methods for achieving consistency in certain situations. In this article, we will explore various alternative methods of achieving consistency in accounting, along with their definitions, explanations, examples, and case studies.
LIFO (Last-in, First-out) vs. FIFO (First-in, First-out) Inventory Valuation Methods:
Inventory valuation is an important aspect of accounting consistency, as it affects the reported cost of goods sold, gross profit, and net income. LIFO and FIFO are two alternative methods for valuing inventory, and they have different implications for financial reporting. LIFO assumes that the last items purchased are the first ones sold, while FIFO assumes that the first items purchased are the first ones sold.
Suppose a company purchases 100 units of a product at different prices: 50 units at $10 each and 50 units at $12 each. At the end of the period, the company has 80 units remaining in inventory. If the company uses LIFO, the cost of the remaining inventory will be based on the cost of the 50 units purchased at $12 each. If the company uses FIFO, the cost of the remaining inventory will be based on the cost of the 30 units purchased at $10 each.
ABC Ltd, a manufacturing company, has been using the LIFO method for inventory valuation for several years. However, due to changes in business operations and market conditions, the company decides to switch to the FIFO method to provide more accurate financial information to its stakeholders. The company discloses the change in accounting policy in its financial statements and provides detailed explanations of the reasons for the change.
Straight-line vs. Accelerated Depreciation Methods:
Depreciation is the allocation of the cost of a long-term asset over its useful life, and it affects the reported value of assets, accumulated depreciation, and net income. Straight-line and accelerated depreciation methods are two common alternatives for calculating depreciation.
Straight-line depreciation allocates the same amount of depreciation expense evenly over the useful life of an asset. Accelerated depreciation methods, such as the declining balance method or the sum-of-the-years’ digits method, allocate more depreciation expense in the earlier years of an asset’s life and less in the later years.
Suppose a company purchases a machine for $10,000 with a useful life of 5 years and no salvage value. If the company uses straight-line depreciation, the annual depreciation expense will be $2,000 ($10,000 divided by 5 years). If the company uses the declining balance method with a depreciation rate of 40%, the depreciation expense in the first year will be $4,000 (40% of $10,000), and the depreciation expense in the second year will be $2,400 (40% of the remaining book value of $6,000).
XYZ Corp, a construction company, has been using the declining balance method for depreciation, which results in higher depreciation expense in the earlier years of asset usage. However, the company decides to switch to the straight-line method to provide a more stable and predictable pattern of depreciation expense, which better aligns with its business operations and financial objectives. The company discloses the change in accounting policy in its financial statements and provides a detailed explanation of the reasons for the change.
The equity method is used when an investor has significant influence over the investee, which is generally defined as having the ability to exercise control over the financial and operating policies of the investee. Under the equity method, the investor records its share of the investee’s income or loss and adjusts the investment account accordingly. The cost method, on the other hand, is used when an investor does not have significant influence over the investee and records its investment at cost.
The equity method recognizes the investor’s share of the investee’s earnings or losses in the investor’s income statement, and the investment is reported in the balance sheet as the initial cost of the investment plus or minus the investor’s share of the investee’s net income or loss. The cost method, on the other hand, only recognizes dividends received from the investee as income and does not adjust the investment account for the investee’s earnings or losses.
Suppose a company, ABC Inc., owns 40% of the voting shares of XYZ Corp. If ABC Inc. uses the equity method, it would recognize 40% of XYZ Corp.’s net income or loss in its income statement and adjust the investment account accordingly. If ABC Inc. uses the cost method, it would only recognize dividends received from XYZ Corp. as income in its income statement and keep the investment account at its initial cost.
Company A has been using the equity method for accounting for its investment in Company B, in which it owns a significant stake. However, due to changes in the business relationship and the level of influence over Company B, Company A decides to switch to the cost method. The change in accounting policy is disclosed in Company A’s financial statements, along with a detailed explanation of the reasons for the change, and the impact on the financial statements is clearly presented.
Cash Basis vs. Accrual Basis of Accounting:
Another alternative method for achieving consistency in accounting is the choice between cash basis and accrual basis of accounting. The cash basis recognizes revenue and expenses when cash is received or paid, while the accrual basis recognizes revenue and expenses when they are earned or incurred, regardless of when cash is received or paid.
The cash basis of accounting records revenue when cash is received and expenses when cash is paid. The accrual basis of accounting records revenue when it is earned and realizable, and expenses when they are incurred and can be reasonably estimated.
The cash basis is relatively simple and easy to apply, but it may not accurately reflect the financial performance and position of an entity, as it does not consider the timing of when revenue is earned and expenses are incurred. The accrual basis, on the other hand, provides a more accurate picture of an entity’s financial performance and position, as it recognizes revenue and expenses in the period in which they are earned or incurred, regardless of when cash is received or paid.
Suppose a company provides services to a customer in December 2022 but does not receive payment until January 2023. Under the cash basis of accounting, the revenue would be recognized in January 2023 when cash is received. However, under the accrual basis of accounting, the revenue would be recognized in December 2022 when the service is provided and earned, regardless of when cash is received.
XYZ Corp, a consulting firm, has been using the cash basis of accounting for its financial statements. However, as the company grows and becomes more complex, it decides to switch to the accrual basis of accounting to provide more reliable and meaningful financial information to its stakeholders. The change in accounting policy is disclosed in XYZ Corp’s financial statements, along with a detailed explanation of the reasons