Accounting Concepts and the Accounting Equation
Meaning, objectives and users of accounting, the main concepts and conventions, and how every transaction keeps Assets = Liabilities + Capital in balance.
4 min readUpdated
What accounting is
Accounting is the process of identifying, measuring, recording, classifying and summarising the financial transactions of an entity and communicating the results to the people who take decisions. Book-keeping is only the recording part; accounting goes further and summarises, analyses and interprets.
Main objectives:
- keep a systematic and complete record of transactions
- find the profit or loss of a period
- show the financial position (assets, liabilities and capital) on a given date
- supply information to users for decision-making and control
Users of accounting information
- Internal users: owners, management, employees.
- External users: investors, lenders such as banks, suppliers and other creditors, customers, government and tax authorities, regulators, the public.
The IFRS Conceptual Framework, on which Nepal Financial Reporting Standards (NFRS) are based, treats existing and potential investors, lenders and other creditors as the primary users of general purpose financial reports.
Concepts and conventions
| Concept | Meaning |
|---|---|
| Business entity | The business is separate from its owner. The owner's private house or household expenses stay out of the books. |
| Money measurement | Only events that can be expressed in money are recorded. |
| Going concern | The business is assumed to continue in operation for the foreseeable future, so assets are not shown at break-up value. |
| Accounting period | The life of the business is cut into periods, normally one year. |
| Dual aspect | Every transaction has two equal effects. This is the basis of double entry and of the accounting equation. |
| Accrual | Income is recorded when earned and expense when incurred, whether or not cash has moved. |
| Matching | Expenses of a period are set against the revenue of the same period. |
| Consistency | The same policies are followed from year to year so that results can be compared. |
| Prudence (conservatism) | Caution under uncertainty: provide for likely losses, do not anticipate profits. Stock at the lower of cost and net realisable value is the classic example. |
| Materiality | An item matters if leaving it out or misstating it could influence users' decisions. Trivial items need no strict treatment. |
The Conceptual Framework groups the qualities of useful information as follows:
- Fundamental: relevance and faithful representation.
- Enhancing: comparability, verifiability, timeliness and understandability.
The 2018 Framework describes prudence as the exercise of caution when making judgements under conditions of uncertainty. It supports neutrality and does not allow deliberate understatement of assets or income.
The accounting equation
Assets = Liabilities + Capital, so Capital = Assets - Liabilities.
Both sides always stay equal because each transaction has a dual effect:
| Transaction | Effect |
|---|---|
| Owner brings in cash Rs 500,000 | Assets + 500,000; Capital + 500,000 |
| Furniture bought on credit Rs 40,000 | Assets + 40,000; Liabilities + 40,000 |
| Creditor paid Rs 70,000 | Assets - 70,000; Liabilities - 70,000 |
| Goods costing Rs 80,000 sold for Rs 110,000 cash | Cash + 110,000, Stock - 80,000; Capital + 30,000 (profit) |
| Rent paid Rs 10,000 | Assets - 10,000; Capital - 10,000 (expense) |
Profit increases capital; expenses, losses and drawings reduce it.
Finding profit from capital:
Closing capital = Opening capital + Additional capital + Profit - Drawings
Example: opening capital Rs 400,000, additional capital Rs 50,000, drawings Rs 30,000, closing capital Rs 520,000.
Profit = 520,000 - 400,000 - 50,000 + 30,000 = Rs 100,000.
Exam pointers
- Assets = Liabilities + Capital holds after every single transaction.
- A credit purchase of an asset raises assets and liabilities by the same amount; capital is unchanged.
- Unpaid expenses still charged to the year point to the accrual concept; stock at the lower of cost and net realisable value points to prudence.
- Owner's private affairs kept out of the books is the business entity concept.
- Relevance and faithful representation are fundamental characteristics; comparability, verifiability, timeliness and understandability are enhancing ones.
- Profit = Closing capital - Opening capital - Additional capital + Drawings.
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Sources
- Conceptual Framework for Financial Reporting, IFRS Foundation
- Conceptual Framework Project Summary (March 2018), IFRS Foundation
- IAS 1 Presentation of Financial Statements, IFRS Foundation
Rates, limits and figures change. Confirm anything time-sensitive against the latest official notice before the exam.