The Basic Accounting Equation Financial Accounting

The Basic Accounting Equation Financial Accounting

which of the statements correctly represents the accounting equation?

Distribution of earnings to ownership (shareholders) is called a dividend. The dividend could be paid with cash or be a distribution of more business shares to current shareholders. The owners’ investments in the business typically come in the form of issued shares and are called contributed capital. Owners/shareholders can invest by contributing cash or some other asset. Insurance, for example, is usually purchased for more than one month at a time (six months typically). The business does not use all six months of the insurance at once, it uses it one month at a time.

This is usually considered the most important of the financial statements, since it presents the operating results of an entity. Accounts payable recognises that the business owes money and has not paid. Remember, when a customer purchases something “on account” it means the customer has asked to be billed and will pay at a later date.


They have contributed to top tier financial publications, such as Reuters, Axios, Ag Funder News, Bloomberg, Marketwatch, Yahoo! Finance, and many others. The working capital formula is Current Assets – Current Liabilities. Consider an end-to-end payables solution that automates the easy stuff, so you can focus on growth.

which of the statements correctly represents the accounting equation?

When Maxidrive sells its disk drives to Dell and others, it sells them on credit and receives promises to pay called accounts receivable, which are collected in cash later. Assets are listed on the balance sheet by ease of conversion to cash. Most financial statements include the monetary unit sign (in the United States, the $) beside the first dollar amount in a group of items (e.g., the cash amount in the assets). Also, it is common to place a single underline below the last item in a group before a total or subtotal (e.g., land). A dollar sign is also placed beside group totals (e.g., total assets) and a double underline below.

The Accounting Process

Demonstrate how to record this transaction in the
accounting equation. The accounting equation is fundamental to the double-entry accounting system and, put simply, it states that the assets of a business must equal its liabilities & owner’s equity. Accumulated Other Comprehensive Income (Loss), AOCIL, is a component of shareholders’ equity besides contributed capital and retained earnings. Although the balance sheet always balances out, the accounting equation can’t tell investors how well a company is performing. The accounting equation states that a company’s total assets are equal to the sum of its liabilities and its shareholders’ equity. This category includes any obligations the company might have to third parties, such as accounts payable, deferred revenue, or other debts.

  • This can lead to inaccurate reporting of financial statements and incorrect decisions made by management regarding money and investment opportunities.
  • Medium-sized companies such as Maxidrive often report in thousands of dollars; that is, they round the last three digits to the nearest thousand.
  • Put another way, it is the amount that would remain if the company liquidated all of its assets and paid off all of its debts.
  • These retained earnings are what the business holds onto at the end of a period to reinvest in the business, after any distributions to ownership occur.

As each month passes, the business will adjust its records to reflect the cost of one month of insurance usage. In our examples below, we show how a given transaction affects the accounting equation. We also show how the same transaction affects specific accounts by providing the journal entry that is used to record the transaction in the company’s general ledger. Examples of such assets include cash & equivalents, marketable securities, accounts receivables.

Assets and the expanded accounting equation

Essentially, the representation equates all uses of capital (assets) to all sources of capital, where debt capital leads to liabilities and equity capital leads to shareholders’ equity. The accounting equation is a concise expression of the complex, expanded, and multi-item display of a balance sheet. Thus, the accounting equation is always matched in all of the above transactions, i.e., increase/ decrease takes place with the same amount. Show the impact of the following transactions in the accounting equation. Unearned revenue represents a customer’s advanced payment for a product or service that has yet to be provided by the business.

The accounting equation depicts the company’s valuable resources representing their obligations in the form of liabilities. It thus helps shareholders determine the company’s worth and establish the relationship between them. However, it may not give investors the proper knowledge of the company’s future, which may hinder further investment. It also provides insights into the growing trend, which can help stakeholders make sound business and economic decisions.

The Accounting Equation

The balance sheet of Maxidrive Corp., presented by its former owners to Exeter Investors, is shown in Exhibit 1.2. The statement of retained earnings presents changes in equity during the reporting period. The report format varies, but can include the sale or repurchase of shares, dividend payments, and changes caused by reported profits or losses.

which of the statements correctly represents the accounting equation?

Every dollar Maxidrive pays to stockholders as a dividend is not available for use in paying back its debt to American Bank. Investors examine retained earnings to determine whether the company is reinvesting a sufficient portion of earnings to support future growth. Exeter Investors was interested in Maxidrive’s debts because of its concern about whether the company has sufficient sources of cash to pay its debts. Maxidrive’s debts were also relevant to American Bank’s decision to lend money to the company because existing creditors share American Bank’s claim against Maxidrive’s assets.

To illustrate how the accounting equation works, let us analyze the transactions of a fictitious corporation, First Shop, Inc. From the following statements, identify the correct definition of a liability. A company’s
obligation to provide assets, products or services to others.

which of the statements correctly represents the accounting equation?