Financial statements of one accounting period must be comparable to another in order for the users to derive meaningful conclusions about the trends in an entity’s financial performance and position over time. Comparability of financial statements over different accounting periods can be ensured by the application of similar accountancy policies over a period of time.
A change in the accounting policies of an entity may be required in order to improve the reliability and relevance of financial statements. A change in the accounting policy may also be imposed by changes in accountancy standards. In these circumstances, the nature and circumstances leading to the change must be disclosed in the financial statements.
Financial statements of one entity must also be consistent with other entities within the same line of business. This should aid users in analyzing the performance and position of one company relative to the industry standards. It is therefore necessary for entities to adopt accounting policies that best reflect the existing industry practice.
If a company that retails leather jackets valued its inventory on the basis of FIFO method in the past, it must continue to do so in the future to preserve consistency in the reported inventory balance. A switch from FIFO to LIFO basis of inventory valuation may cause a shift in the value of inventory between the accounting periods largely due to seasonal fluctuations in price.
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How must a change in accounting policy be accounted for to preserve comparability and consistency in the financial statements?
Changes to accounting policy should not be allowed.
Changes to accounting policies may be required from time to time as a result of changes in law or accounting standards or in instances where a change in accounting policy results in more reliable and relevant information to users of the financial statements.
Changes to accounting policy must be accounted for prospectively, i.e. resulting change should not have impact on prior period financial statement comparatives.
If the effect of a change in accounting policy is accounted for only in the current accounting period, there will be inconsistency between the current period financial statements and prior period financial statements because of application of different accounting policies.
Changes to accounting policy must be accounted for retrospectively, i.e. amounts recognized in previous accounting periods are restated to account for the change in accounting policy.
Applying a change in the accounting policy retrospectively will help the users in making valid comparisons between current period financial statements and past period comparative financial statements because both will be based on similar accounting policies. However, changes to accounting policy should only be made where required by a change in law or accounting standard or where a change results in a more relevant and reliable information to the users.