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Understanding the fundamental principles of accounting systems
All accounting professionals should have a firm grasp of the accounting equation, separate entity and duality concepts. Here’s how they work.
Words Gill Myers, Evolve
You know that buzz you get when you realise that you must have posted all the transactions in a trial balance correctly as the total debits equal the total credits? Do you then just move on to the next question, pleased that it worked out – or have you ever stopped to think about why it worked?
Three fundamental principles
The accounting equation states that everything an organisation owns in assets, less everything it owes in liabilities, is equal to the capital that its owner(s) have invested in it at any given time:
Assets − Liabilities = Capital
Assets can be non-current, such as property, vehicles, machinery and equipment. They are the result of capital expenditure on items needed by an organisation in order to operate in the long term. They can also be current; in other words, assets owned in the short term such as inventory, money held in bank accounts and amounts due from customers who have been invoiced but are yet to pay for the goods or services they have been sold.
Liabilities are categorised in the same way. Loans that will be repaid over a period of more than 12 months are non-current, whereas a bank overdraft is a current liability.
Capital is a liability as well. However, it is only ever owed to the owner(s) of an organisation, be that a sole trader, partner or shareholder of a limited company. That makes it fundamentally different to non-current and current liabilities that are owed to, for example, the bank, HMRC or suppliers.
This means that the accounting equation can also be written as:
Assets = Liabilities + Capital or Assets = Liabilities
It also requires the application of the separate entity concept to work. This principle means that for the purpose of maintaining financial records, the transactions of an organisation are kept separate from the personal financial affairs of the organisation’s owner(s). Therefore, when a sole trader starts a business, the initial capital introduced is owed back to them.
For example, if £50,000 is paid into a business bank account, that means the business has both a current asset and capital owed to the sole trader.
The separate entity concept has been applied and the accounting equation balances:
The principle of duality or dual effect has also been applied. This third principle requires that each financial transaction has two effects on the accounts. For example, in this scenario, the single transaction of paying money into the business bank account has increased assets and increased capital.
If the sole trader then buys a vehicle for £8,000 and pays by bank transfer, the transaction will decrease the bank balance and increase the value of non-current assets. The accounting equation will remain in balance:
Principles combined
Every transaction that is entered into an accounting system requires the combination of these three principles to be applied for a trial balance, and ultimately the statement of financial position, to balance.
The statement of financial position is essentially an expanded version of the accounting equation and is one of the reports that make up an organisation's year-end accounts. It shows the value of assets and liabilities, and calculates the capital.
There are two other categories of accounts – expenses and income – and these are shown on the profit and loss statement. This calculates the profit or loss at year-end, which is then either added to, or subtracted from, the capital on the statement of financial position.
The combination of these fundamental principles is the theoretical basis of double-entry bookkeeping, which works by using debits and credits to increase and/or decrease account balances depending on their category:
If the sole trader in the scenario buys £2,000 of goods for resale and agrees to pay for them the following month, the double-entry postings need to increase purchases and increase payables. As purchases are an expense, the account will have a debit balance so will be debited £2,000 to increase it. The payables control account records amounts owed to suppliers, which are current liabilities, therefore it will have a credit balance and will be credited £2,000 to increase it. The principle of duality has been applied and the accounting equation will balance.
KEY TAKEAWAYS
Accounting records don’t balance by magic or even good luck. Accurate financial statements are the result of the combination of the accounting equation, separate entity and duality principles. These form the basis of double-entry bookkeeping and enable individuals (and/or accounting software) to determine the correct entries to make in general ledger accounts, based on their account categories and whether the balances need to be increased or decreased.
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