Accounting Concepts, Conventions and the Accounting Equation
What the exam tests
This domain tests the concepts that underpin double entry: business entity, going concern, accrual, matching, consistency, materiality, prudence, realisation and money measurement. It also tests the accounting equation and how transactions change it.
Core rules
- Accounting equation: Assets = Capital + Liabilities. Expanded: Assets = Capital + Profit - Drawings + Liabilities.
- Every transaction affects at least two elements and keeps the equation balanced.
- Accrual records income when earned and expenses when incurred, not when cash moves.
- Going concern assumes the entity will continue for the foreseeable future; consistency applies the same policy each period unless a change is justified and disclosed.
- Materiality permits aggregation or omission only when the effect cannot influence decisions.
Worked example
A trader has assets N850,000 and liabilities N300,000, so capital is N550,000. During the year profit is N120,000 and drawings are N70,000. Closing capital = 550,000 + 120,000 - 70,000 = N600,000. If closing assets are N900,000, closing liabilities must be N300,000. The equation still balances: 900,000 = 600,000 + 300,000. Notice that drawings reduce capital but are not an expense, while profit increases capital through the statement of profit or loss.
Traps
Do not charge drawings to profit or loss. Do not record a cash purchase of inventory as an expense if the inventory remains unsold; it is an asset until sold. A change in policy is not a breach of consistency if it is justified, disclosed and applied retrospectively where required.