Future Business Leaders of America (FBLA) Accounting Practice Test

What is the relationship defined by the accounting equation?

1. Income = Expenses

2. Assets = Liabilities - Owner's Equity

3. Assets = Liabilities + Owner's Equity

4. Owner's Equity = Revenues + Expenses

The correct answer is: Assets = Liabilities + Owner's Equity

The accounting equation establishes a fundamental relationship within the balance sheet, illustrating how a company’s resources (assets) are financed through debts (liabilities) and the owners’ investments (owner's equity). This equation is represented as Assets equal Liabilities plus Owner's Equity. When assets are acquired, they can either be funded through borrowing (creating liabilities) or through contributions from owners (increasing owner’s equity). This balance ensures that the total resources a company owns (assets) are always equal to the claims against those resources, which include what is owed to creditors (liabilities) and the residual interest of the owners (owner's equity). Understanding this relationship is vital for recording transactions, preparing financial statements, and maintaining accurate financial records, as it reflects the overall health and stability of a business.