Accounting Concepts, Principles and the Accounting Equation
The foundations
Every figure in a set of accounts rests on a few ideas. Entity treats the business as separate from its owner. Going concern assumes it will keep trading. Accruals (matching) puts income and expenses in the period they relate to, not when cash moves. Prudence stops you overstating assets or profits. Consistency means using the same methods each year, and materiality lets you ignore trivial amounts. Duality says every transaction has two effects.
The equation
The accounting equation is Assets = Capital + Liabilities. Capital is what the owner is owed by the business. Profit increases capital; drawings reduce it. Rearranged, Capital = Assets − Liabilities.
Traps candidates fall into
- Confusing drawings with expenses. Drawings are a reduction of capital, never a business expense.
- Treating a loan received as income. It is a liability.
- Mixing the owner's personal cash with business cash, breaching the entity concept.
- Forgetting that buying an asset on credit leaves the equation balanced: assets rise, liabilities rise.
Worked example
A trader starts with $5,000 cash and a $2,000 bank loan. Assets = 5,000; liabilities = 2,000; capital = 3,000. She then buys equipment for $1,500 cash. Cash falls to 3,500, equipment rises to 1,500, so total assets stay at 5,000. The equation still balances. Rule of thumb: after every transaction, total assets must still equal capital plus liabilities.