Future Business Leaders of America (FBLA) Accounting Practice Test

What does the accounting equation illustrate?

1. Income and expenses

2. The relationship among assets, liabilities, and owner's equity

3. Only the profit of a business

4. The cash flow of the business

The correct answer is: The relationship among assets, liabilities, and owner's equity

The accounting equation is fundamental to the field of accounting and serves to illustrate the relationship among a company’s assets, liabilities, and owner's equity. This equation is expressed as: Assets = Liabilities + Owner's Equity This means that all the resources a company owns (assets) must be financed either by borrowing (liabilities) or by contributions from the owners (owner's equity). Understanding this relationship is essential because it helps ensure that a company's financial statements are balanced, which is a key principle in accounting. Every financial transaction affects at least two of these components, maintaining the balance reflected in the equation. For instance, when a company takes on debt (increasing liabilities), it also acquires an asset (such as cash or inventory). Similarly, when owners invest cash into the business, it increases both the cash (asset) and the owner’s equity. This balance is critical for stakeholders to assess the financial health and stability of the organization. Therefore, the correct answer effectively captures the essence of the accounting equation and its importance in the accounting process.