CHAPTER 2 The Basic Model

CHAPTER 2 The Basic Model - Review of the Accounting...

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Review of the Accounting Process 1 THE BASIC MODEL The accounting information system is designed to collect and organize data into information that is useful for stakeholders. The Accounting Equation The basic accounting equation is what drives double-entry bookkeeping. The equation reflects the accounts reported in the balance sheet. The basic accounting equation is as follows: ASSETS = LIABILITIES + OWNERS' EQUITY This is a very simple algebraic equation that reflects that the assets of an entity must be supported by either debt or equity. As in algebra if we add or subtract something from one side of the equation we must add or subtract the same amount on the other side of the equation. For example, if we were to increase cash (an asset) we might have to increase note payable (a liability account) so that the basic accounting equation remains in balance. ASSETS = LIABILITIES + OWNERS' EQUITY $500 = $500 In accounting language an increase in an asset account is called a debit and an increase in a liability or equity account is called credit . Likewise, if we decrease in asset account we credit the account and on the other side of the equation we debit a liability or equity account which reduces its balance. The normal balance in an asset account is a debit. In contrast, to keep the accounting equation in balance the normal balance in a liability or equity account is a credit. The accounting equation provides the foundation for what eventually becomes the balance sheet. T-Account Analysis In double-entry bookkeeping, the terms debit and credit are used to identify which side of the ledger account an entry is to be made. Debits are on the left side of the ledger and Credits are on the right side of the ledger. It does not matter what type of account is involved. For example if we received $500 in cash as a loan from the bank, the entry would be as follows: Debit Credit Debit Credit $500 $500 CASH NOTE PAYABLE The debit to cash increases the Cash Account by $500 while the credit to Note Payable increases this liability account by the same $500. Above, we analyzed the accounting equation in terms of assets, liabilities and owners’ equity. These are called real or permanent accounts . By this we mean that these accounts remain open and active for the life of the enterprise. In contrast there are accounts that reflect activities for a specific accounting period. These are called nominal or temporary accounts .
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Review of the Accounting Process 2 Using the accounting equation format we can now expand our analysis to include both real and nominal accounts. The nominal accounts reflect an accumulation of transactions for a specific accounting period. Each account is closed to the Retained Earnings account at the end of the accounting period, which is an owners’ equity (stockholders’ equity) account.
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CHAPTER 2 The Basic Model - Review of the Accounting...

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