Principles of Accounting
The accounting equation and double entry
Assets = Liabilities + Equity. Every transaction affects at least two accounts and the equation stays balanced. Debits increase assets and expenses; credits increase liabilities, equity and income. The trial balance proves arithmetic equality only - it does not detect omitted transactions or compensating errors.
Accrual, matching and adjusting entries
Accrual accounting records revenue when earned and expenses when incurred, regardless of cash movement. Adjusting entries at period end handle accruals (earned but unbilled revenue; incurred but unpaid expense), prepayments, depreciation and inventory. Depreciation allocates cost over useful life; it is not a valuation of the asset.
Statements
Income statement: revenue less expenses equals profit. Balance sheet: a snapshot of assets, liabilities and equity. Cash flow statement: operating, investing and financing activities. Closing entries transfer profit to retained earnings and reset temporary accounts.
Traps to watch
- Treating a cash receipt as revenue under accrual accounting.
- Confusing capital expenditure (asset) with revenue expenditure (expense).
- Forgetting that drawings reduce equity.
- Mixing the cash flow statement with the income statement - a profitable firm can still run out of cash.
Worked example
A firm pays 12,000 in advance for one year of insurance on 1 April, year-end 31 December. Monthly expense = 12,000 / 12 = 1,000. By year-end, 9 months (9,000) is expense; 3,000 remains a prepaid asset. Rule of thumb: split every prepayment by time elapsed, and post the unused portion to the balance sheet.