General Education Development (GED) Practice Exam

Which of the following correctly summarizes the accounting equation for a sole proprietorship?

1. Assets = Liabilities + Owners' equity

2. Liabilities = Assets + Owners' equity

3. Owner's equity = Assets + Liabilities

4. Revenue = Assets - Liabilities

The correct answer is: Assets = Liabilities + Owners' equity

The accounting equation is fundamental in accounting and illustrates the relationship between a business's resources and the claims against those resources. For a sole proprietorship, the correct formulation of the accounting equation is that assets are equal to the sum of liabilities and owners' equity. This means that everything the business owns (assets) is financed either by borrowing (liabilities) or by the owner's own investment (owners' equity). Consequently, this equation demonstrates the balance that must always be maintained in financial statements, ensuring that every transaction affects both sides equally. Other statements, while they reference components of the accounting equation, do not reflect the correct relationships. For instance, the equation suggesting liabilities as equal to the sum of assets and owners' equity would not hold true according to standard accounting principles. Similarly, the option placing owner's equity as the sum of assets and liabilities misrepresents the way claims against a business's resources are outlined. Finally, the mention of revenue in the context of the equation indicates a misunderstanding of how revenue and equity interrelate in accounting. Understanding this core principle of accounting is essential for accurate financial reporting and analysis, particularly in managing a sole proprietorship.