AU 420: Consistency of Application of Generally Accepted Accounting Principles

AU-C 708: Consistency of Financial Statements

AU EFFECTIVE DATE AND APPLICABILITY

Original Pronouncements Statements on Auditing Procedures (SAPs) 53, 43, and 88.
Effective Date These statements currently are effective.
Applicability Audit of financial statements in accordance with generally accepted auditing standards (GAAS).
NOTE: The consistency standard does not apply in the audit of the financial statements of a new entity. It applies either to financial statements prepared in accordance with generally accepted accounting procedures (GAAP) or another comprehensive basis of accounting.

AU-C EFFECTIVE DATE AND SUMMARY OF CHANGES

SAS No. 122, Codification of Auditing Standards and Procedures, is effective for audits of financial statements with periods ending on or after December 15, 2012.

The clarified standard supersedes AU Section 420 (SAS No. 1, Codification of Auditing Standards and Procedures, Section 420, Consistency of Application of Generally Accepted Accounting Principles, as amended)

The clarified SAS does not change or expand existing standards in any significant respect except as follows:

  • AU Section 420 states that changes and material reclassifications made in previously issued financial statements to enhance comparability with current financial statements ordinarily would not need to be referred to in the independent auditor’s report. However, the clarified SAS requires the auditor to compare and evaluate a material change in financial statement classification and the related disclosure to determine whether such a change is also either a change in accounting principle or an adjustment to correct a material misstatement in previously issued financial statements. If so, the requirements in the clarified SAS apply.
  • The clarified SAS recognizes that the applicable financial reporting framework usually sets forth the method of accounting for accounting changes and, therefore, the references to accounting guidance included in AU Section 420 have not been included in the clarified SAS.
  • To reflect a more principles-based approach to standard setting, certain requirements that are duplicative of broader requirements in AU Section 420 have been moved to application and other explanatory material. In the Auditing Standards Board’s (ASB’s) view, this has not changed the overall effectiveness of the clarified SAS.

AU DEFINITIONS OF TERMS

Accounting change. A change in:

1. An accounting principle
2. An accounting estimate
3. The reporting entity (a special type of change in accounting principle)
NOTE: Only a change in accounting principle (items 1 or 3 in the prior list) affects consistency.

Accounting principle. Accounting principles, practices, and the methods of applying them.

NOTE: Other definitions are presented in “Fundamental Requirements” because the definition is the substance of the requirement.

Comparability. Comparison of financial statements between years may be affected by:

1. Accounting changes
2. An error in financial statements of prior years
3. Changes in classification
4. Events or transactions that are substantially different from those of prior periods
NOTE: All these things affect comparability, but only certain accounting changes affect consistency.

AU-C DEFINITIONS OF TERMS

Source: AU-C 708.04

Current period. The most recent period upon which the auditor is reporting.

OBJECTIVES OF AU SECTION 420

Before APB Opinion 20, Accounting Changes, was issued, most of the accounting guidance as well as audit reporting guidance on accounting changes was covered in the auditing literature. An important feature of the auditing guidance was a distinction between changes in circumstances that caused accounting changes and other, presumably discretionary, changes. Only a discretionary change affected consistency reporting.

Opinion 20 established several new accounting requirements and codified some existing practices. Opinion 20:

1. Created a presumption that an accounting principle, once adopted, should not be changed in accounting for similar transactions or events. The presumption can be overcome only if the new accounting principle is justified as being preferable.
2. Specified the accounting treatment of the effect of accounting changes on the financial statements. This is essentially a cumulative-effect adjustment except for certain specified changes made by retroactive restatement.
3. Specified the disclosure requirements for various types of accounting changes.

Opinion 20 does not apply to changes made to conform to new authoritative pronouncements, but such pronouncements specify the applicable accounting treatment and disclosure.

The auditing literature was modified to mesh with Opinion 20. The old distinction between changes in circumstances and other changes disappeared. The auditing literature adopted the classification of accounting changes of Opinion 20 and specified those that affect consistency and those that do not. Once a change is put in the slot specified in Opinion 20, reference to lists of changes affecting and not affecting consistency reporting in this section determines the appropriate reporting on consistency.

Although these refinements have been made in consistency reporting, the basic objective of consistency reporting by the auditor has remained the same. It is:

1. To give assurance that the comparability of financial statements between periods has not been materially affected by changes in accounting principle.
2. If comparability has been materially affected by changes in accounting principle, to require appropriate reporting by the independent auditor on the changes

OBJECTIVES OF AU-C SECTION 708

AU-C section 708 states that:

. . . the objectives of the auditor are to

a. evaluate the consistency of the financial statements for the periods presented and
b. communicate appropriately in the auditor’s report when the comparability of financial statements between periods has been materially affected by a change in accounting principle or by adjustments to correct a material misstatement in previously issued financial statements.

FUNDAMENTAL REQUIREMENTS

Reporting Standard

According to AU 420.01, the second standard of reporting is: “The auditor must identify in the auditor’s report those circumstances in which such principles have not been consistently observed in the current period in relation to the preceding period.”

Consistency Implication of Auditor’s Standard Report

According to AU 411.04, the auditor’s standard report implies that the auditor is satisfied that the comparability of financial statements between periods has not been materially affected by changes in accounting principles and that such principles have been consistently applied between or among periods because either (1) no change in accounting principles has occurred, or (2) there has been a change in accounting principles or in the method of their application, but the effect of the change on the comparability of the financial statements is not material. In these cases, the auditor would not refer to consistency in his or her report.

A change in accounting principle that has a material effect on the comparability of financial statements requires an explanatory paragraph after the opinion paragraph in the auditor’s report.

Periods to Which Consistency Standard Relates

The financial statements included in the consistency implication depend on what financial statements are covered by the auditor’s report:

1. Current period only—the consistency of application of accounting principles in relation to the preceding period only (even if financial statements for one or more preceding periods are presented)
2. Two or more years (no other statements presented)—the consistency of application of accounting principles between such years
3. Two or more years (prior year presented but not included in auditor’s report)—consistency between years included in report and also the consistency of such years with the prior year

Changes Affecting Consistency

The following changes, if they have a material effect, require the addition of an explanatory paragraph after the opinion paragraph that describes the inconsistency.

1. Change in Accounting Principle

Adoption of a GAAP different from the one used in the prior period. An example is a change from the straight-line method to the declining balance method of depreciation for all newly acquired assets in a class. An investee accounted for by the equity method may change an accounting principle. If this change causes a material lack of comparability in the financial statements of the investor, the auditor should add an explanatory paragraph to the auditor’s report following the opinion paragraph.

2. Change in Reporting Entity

This is a special type of change in accounting principle and is limited mainly to:

a. A presentation of consolidated or combined statements instead of statements of individual entities
b. A change in specific subsidiaries included in the group of entities in the consolidation
NOTE: This means a change in consolidation policy and not the creation, cessation, purchase, or disposition of a subsidiary.
c. A change in entities included in combined financial statements

3. Correction of an Error in Principle

A change from an accounting principle that is not generally accepted to one that is, including correcting a mistake in applying a principle.

NOTE: APB Opinion 20 specifies that the accounting treatment of the change is the correction of an error, but the method of accounting for the change does not affect its classification as a change in accounting principle for audit reporting purposes.

4. Change in Principle Inseparable from Change in Estimate

A change in estimate that is achieved by changing an accounting principle. An example is changing from deferring and amortizing a cost to expensing it when incurred because future benefits of the cost have become doubtful.

NOTE: Again, although the accounting treatment is that for a change in estimate, the change in principle affects audit reporting.

5. Changes in Presentation of Cash Flows

A change in an entity’s policy for determining which items are treated as cash equivalents. This type of change should be effected by restating financial statements for earlier years presented for comparative purposes. This change in the presentation of cash flows requires the addition of an explanatory paragraph after the opinion paragraph.

Changes Not Affecting Consistency

The following changes, if they have a material effect on comparability, require disclosure in the financial statements but have no effect on the auditor’s report and its implications for consistency.

1. Change in Accounting Estimate

Examples of items for which estimates are made include uncollectible receivables, inventory obsolescence, warranty costs, and service lives and salvage values of depreciable assets. As new events occur or additional information is obtained, a change in such accounting estimates may be necessary.

2. Error Correction Not Involving Principle

Correction of an error not involving an accounting principle includes mathematical mistakes, oversight, or misuse of facts that existed when the financial statements were originally prepared.

3. Changes in Classification or Reclassification

Use of classifications within the financial statements different from classifications in prior years may be made. For example, “cash on hand” might be combined with “cash in bank” in a new classification, “cash.”

NOTE: A change in classification that significantly affects measurement of financial position or operating results requires a consistency modification—for example, a change in types of items reported as extraordinary.

4. Substantially Different Transactions or Events

Accounting principles are adopted when events or transactions first become material. Initial adoption or modification of an accounting principle necessitated by transactions or events clearly different in substance from past transactions or events does not affect consistency.

5. Changes Expected to Have a Material Future Effect

If an accounting change has no material effect on the current financial statements but is reasonably certain to have a substantial future effect, disclosure of the change should be made whenever the statements of the period of the change are presented but need not cause modification of the audit report.

NOTE: This means that the auditor does not have to modify the audit report for the inconsistency, but modification is permissible if the auditor wishes.

First Year Audits

If the independent auditor has not audited an entity’s financial statements for the preceding year, he or she should apply reasonable and practicable procedures, such as reviewing underlying financial records and predecessor auditor’s audit documentation, to obtain assurance as to the consistency of accounting principles employed in the current and the preceding year.

The independent auditor may not be able to obtain sufficient, competent evidential matter about the consistent application of accounting principles and the amounts of assets and liabilities at the beginning of the current year. In these circumstances, if these amounts could materially affect current operating results, in addition to modifying the auditor’s report for a scope limitation as to consistency, the independent auditor would also be unable to express an opinion on the current year’s results of operations and cash flows.

INTERPRETATIONS

The Effect of APB Opinion 28 on Consistency (February 1974)

Auditors may be engaged to report on financial information for an annual period and a subsequent interim period. APB Opinion 28 may appear to produce changes in the methods of applying accounting principles. For example, the entity, as permitted under APB Opinion 28, may use the gross profit method to estimate the interim inventory; whereas, for the annual financial statements, a physical inventory may be taken. The modifications permitted by APB Opinion 28 constitute a difference in circumstances, not a change in accounting principle. Therefore, the auditor should not add an explanatory paragraph to the audit report because of an inconsistency.

Impact on the Auditor’s Report of Fifo to Lifo Change in Comparative Financial Statements (January 1975; Amended April 1989)

For a FIFO to LIFO change made in the earlier year presented and reported on (20X2 and 20X1 comparative financial statements presented—change made in 20X1), there is no inconsistency in the application of accounting principles. Comparability between the earliest year and subsequent year(s) is not affected, since no cumulative effect is reported in the year of change. (There is no cumulative effect since the ending inventory for 20X0 is the beginning inventory for 20X1 for LIFO purposes.) The auditor should not refer to the change from FIFO to LIFO in his or her report.

The Effect of Accounting Changes by an Investee on Consistency (Issued July 1980; Revised June 1993)

As discussed in “Fundamental Requirements,” a change in accounting principles by an investee accounted for by the equity method requires the auditor to add an explanatory paragraph because of an inconsistency.

Change in Presentation of Accumulated Benefit Information in the Financial Statements of a Defined Benefit Pension Plan (December 1980)

A change in the format of presentation of accumulated benefit information (e.g., on the face of a financial statement or in a separate statement) or a change in the date as of which such information is presented is a reclassification, not an inconsistency.

The Effect on the Auditor’s Report of an Entity’s Adoption of a New Accounting Standard That Does Not Require the Entity to Disclose the Effect of the Change in the Year of Adoption (April 2002)

If an entity adopts an accounting standard and the standard does not require the entity to disclose the effect of the change in the year of adoption, Section 420 does not require the auditor to independently determine the effect of that change. However, this section requires that the auditor add an explanatory paragraph to his or her report for material changes in accounting principles. In determining whether such a paragraph is necessary, the auditor should consider:

  • The materiality of the change’s cumulative effect
  • The entity’s voluntary disclosure about the effect of the change in accounting principle
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