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Fundamental Accounting Equation: Problems and Solutions

UserMark time04 March,2015

Let’s say that you have been coveting that George Brett-autographed baseball bat on an antique shop window for a long time now. The price tag reads $995, and you have only managed to save up $750 so far. If you manage to borrow the rest of the money to pay back later, you might end up buying it. If you were to put the entire transaction of the purchase, you would need a fundamental accounting equation to define it. 

The fundamental accounting equation goes like,

 Assets = Liabilities + Equity or Capital

After purchasing the baseball bat, your assets lie at $995, liabilities at $245 and equity at $750.

That’s all there is to the fundamental accounting equation. You can use the same equation to solve countless accounting problems. This double-entry accounting system relies on the basics of accounting; hence, the name. 

Defining fundamental accounting equation

Investopedia defines the fundamental accounting equation as the foundation of the double-entry accounting system. This shows the company’s balance sheet using the company’s assets or the sum of liabilities and capital/ shareholder’s equity. Since the whole idea is based on balance, the debit side of the equation needs to be equal to that in the credit side.

The equation speaks volumes about a company’s financial position based on the crucial components of the balance sheet, assets and liabilities. Since they are all connected by the equation, you can easily figure out the problems after detailing the same using the equation and its many forms. Here is a basic overview of what assets, liabilities and equities or capitals are.

  • Assets

Assets include cash and cash equivalents in a business such as liquid assets, and may consist of Treasury bills and certificates of deposit. Accounts receivables include the money that customers owe the company.

Examples: equipment, inventory, cash, accounts receivable

  • Liabilities

Liabilities include money that the business owes to keep it operational. Overhead and operational costs, rents, taxes and salaries are all part of the liabilities in a company, as well as payable dividends.

Examples: long-term debt, accounts payable, short-term borrowings

  • Shareholder’s Equity

This represents all the money that the shareholders will receive in case the company liquidates its assets after paying off all the company debts. Capital and shareholder’s equity are, in some cases, used alternatively.

Examples: retained earnings, share capital

Now that you know all about the components of a fundamental accounting equation, let us look at what you need to do to solve them.

How to calculate a fundamental accounting equation?

Since the accounting equation forms the base for double-entry accounting, it can also represent a complex structure on the balance sheet. The balance sheet can feature multiple items that need to be accounted to evaluate total assets and liabilities of the business. So, here are the simple steps you need to follow to calculate accounting problems with fundamental accounting equation accurately.

  • Identify the company’s total assets for the time period mentioned
  • Sum up all the liabilities, and list them separately on the balance sheet
  • Identify the total of shareholders’ equity and add it with total liabilities
  • Check if the total assets equal the sum of liabilities and equity or capital

You can now move on to solving accounting problems using the fundamental accounting equation. Read on to know more through examples, problems and their solutions.

How to solve a basic accounting equation?

Here is an example using the formula Assets = Liabilities + Equity or Capital

Problem: 

Find out how accounting equation is calculated after taking into consideration each of the following transactions in the books of Mr. A

  1. Started business with capital $100,000

Solution

Capital (100,000) + Liabilities (0) = Assets (cash = 100,000)

  1. Bought furniture $25, 000

Solution

Capital (100,000) + Liabilities (0) = Assets (Cash = 75,000 + Furniture = 25,000)

  1. Bought goods for cash $20, 000

Solution

Capital (100, 000) + Liabilities (0) = Assets (Cash = 55,000 + Furniture = 25,000 + Goods = 20,000)

  1. Brought goods from Mr. Nelson on credit $5,000

Solution

Capital (100, 000) + Liabilities (Nelson = 5,000) = Assets (Cash = 55,000 + Furniture = 25,000 + Goods = 25,000)

  1. Sold goods for cash for $15, 000

Capital (100,000) + Liabilities (Nelson = 5,000) = Assets (Cash = 70,000 + Furniture = 25,000 + Goods = 10,000)

  1. Sold goods to Mr. William on credit $8,000

Solution,

Capital (100,000) + Liabilities (Nelson = 5,000) = Assets (Cash = 70,000 + Furniture = 25,000 + Goods = 2,000 + William = 8,000)

  1. Paid cash to Nelson $4,000

Solution,

Capital (100,000) + Liabilities (Nelson = 1,000) = Assets (Cash = 66,000 + Furniture = 25,000 + Goods = 2,000 + William = 8,000)

  1. Received cash from William $5,000

Solution

Capital (100,000) + Liabilities (Nelson = 1,000) = Assets (Cash = 71,000 + Furniture = 25,000 + Goods = 2,000 + William = 3,000)

Types of accounting problems

Fundamental accounting equation helps you solve a wide array of problems for your papers. Whether it is an assignment regarding a corporate ownership or about calculating sole proprietorship, you can do it all using fundamental accounting equation. Here are a few kinds of common problems that your accounting paper may contain.

  • Accounting equation for a corporate
  • Accounting equation for a sole proprietorship
  • Calculating a missing amount within the owner’s equity
  • Expanded accounting equation for a sole proprietorship
  • Expanded accounting Equation for a corporation

We can now deal with each of these with an example. Read on to know more.

Solving the accounting equation for a corporate structure

The accounting equation for the corporation is,

Assets = Liabilities + Stockholder’s Equity

With the help of the examples, you can see how a given transaction affects the accounting equation for a corporation and how the same transaction will be recorded in the company’s general ledger accounts,

Example:

Let’s assume that member of Bill family form a corporation called Accounting Software, Inc. (ASI). On December 1, 2018, several member of Bill family invest a total of $10, 000 to start ASI. In exchange, the corporation issues a total of 1, 000 shares of common stock. The effect on the corporation’s accounting,

Asset (+ $10,000) = Liabilities (no effect) + Stockholder’s Equity (+ $10,000)

The above equation says that, ASI increases its assets and stockholder’s equity by the same amount ($10,000), the sources of these assets was the stockholders. In other words, it states that the corporation has the assets of $10,000, and only stockholders can claim them.

Let us have a look on how the accounting equation for a corporation can affect the balance sheet,

The balance sheet of ASI’s financial position at the end of the December 1, 2018,

Accounting Software Inc.

Balance Sheet

December 1, 2018

AssetsLiabilities
Cash = $ 10,000Stockholder’s equity = $10,000

 

(Common Stock)

Total Assets = $ 10,000Total Liabilities

 

and Stockholder’s Equity = $ 10,000

Solving the accounting equation for a sole proprietorship

A sole proprietor is a kind of business that is owned by one person.

Example:

Let’s assume, Mr. Bill is the sole proprietor of XYZ Co. (ASC). On December 1, 2018, Mr. Bill invests personal funds of $10,000 to start XYZ Co. So after this transaction, the accounting equation will be,

Assets (+ $10,000) = Liabilities (No effect) + Owner’s equity (+ $10,000)

As you can see, the assets and owner’s equity increase by same amount ($10,000), so the accounting equation says that, XYZ Co. possesses assets of $10,000 and the source of those assets was the owner, Mr. Bill. In other words, XYZ Co. has assets of $10,000 and the owner has a claim for the remainder.

Let’s see how balance is affected by the accounting equation for a sole proprietorship,

Here is the balance sheet of ASC at the end of December 1, 2018.

XYZ Co.

Balance Sheet

December 1, 2018

AssetsLiabilities
Cash $ 10,000Liabilities

 

(Owner’s Equity, Mr. Bill Capital)  =  $ 10,000

Total Assets = $10,000Total liabilities and Owner’s equity = $ 10,000
Accounting Equation: Problems And Solutions

Calculating a missing amount within the owner’s equity

Here is an example of how to decide one of the components if it is unknown,

Example:

Let’s assume that the net income for the year 2018 is unknown, but the amount of the draws and the beginning and ending balances of owner’s equity are known, you can calculate the net income. So this is a sample how you should do it taking the same above company as an example,

Assets as of December 31, 2017$100,000
Liabilities as of December 31, 201740,000
Assets as December 31, 2018128,000
Liabilities as of December 31, 201834,000
Owner investment in business in 201810,000
Owner draws in 201840,000

Step 1 The owner’s equity at December 31, 2017 can be computed with the help of the accounting equation

Assets = Liabilities + Owner’s equity

$ 100,000 = $40,000 + Owner’s Equity

Owner’s Equity = $100,000 – $40,000

Owner’s Equity at Dec 31, 2017 =   $60,000

Step 2 The owner’s equity at December, 2018,

Assets = Liabilities + Owner’s equity

$128,000 = $34,000 + Owner’s equity

Owner’s Equity = $128,000 – $34,000

Owner’s Equity at Dec, 31, 2018 = $94,000

Step 3 The ‘subtotal’ can be calculated by adding (Owner’s equity at Dec 31, 2014 + Owner draws in 2018) ($94,000 + $40,000 = $134,000), and after inserting the result ($134,000) n the statement of changes, giving us,

Owner’s Equity at December 31, 2018$60,000  (Step 1)
Add: Owner’s investment+ 10,000 (given)
Net income? ?
Subtotal$134,000 (Step 3)
Deduct : Owner’s Draws-40,000
Owner’s equity at December 31, 2018$94,000 (step 2)

Step 4 The net income is the difference between the

 {(Owner’s Equity at Dec, 31, 2017 + Owner’s investments) – subtotal}

So you can find the result as adding Owner’s equity at Dec, 2017 and Owner’s investments, ($60,000 + $10,000= $70,000), and after subtracting the result ($70,000) from subtotal, ($134,000 – $70,000 = $64,000). So the Net income must have been $64, 000.

Owner’s Equity at December 31, 2018$60,000  (Step 1)
Add: Owner’s investment+ 10,000 (given)
Net income$64,000
Subtotal$134,000 (Step 3)
Deduct : Owner’s Draws-40,000
Owner’s equity at December 31, 2018$94,000 (step 2)

Solving expanded accounting equation

In the expanded accounting equation, Owner’s equity replaces with the following components that are Owner’s Capital + Revenues – Expenses – Owner’s Draws.

  • Expanded accounting equation for a sole proprietorship

The expanded accounting equation for a sole proprietorship is,

Assets = Liabilities + Owner’s Capital + Revenues – Expenses – Owner’s Draws

The eight transactions that already been listed under the basic accounting equation are demonstrated in the expanded accounting equations,

 Assets=Liabilities+Owner’s Capital+Revenues_Expenses_Owner’s Draws
1+10, 000= ++10, 000      
2-100        _+100
3+ 5, 000

 

-5, 000

=         
4+7, 000=+ 7, 000        
5-600=     + 600  
6+900=   ++900    
7 =+ 120    +120  
8+ 500

 

-500

=         
T17, 200=7, 120 10, 000 900 720 100

So, you can calculate the Net Income,

       Revenues ($900) – Expenses ($720) = Net Income ($180)

Solving expanded accounting equation for a corporation

Here is the formula:

Assets = Liabilities + Paid-in Capital + Revenues – Expenses – Dividends – Treasury Stock

So, eight transactions are shown in the following expanded accounting equation in order to find Net Income,

 Assets=Liabilities+Paid-in Capital+Revenues_Expenses_Dividends and Treasury Stock
1+10, 000= ++10, 000      
2-100        _+100
3+ 5, 000

 

-5, 000

=         
4+7, 000=+ 7, 000        
5-600=     + 600  
6+900=   ++900    
7 =+ 120    +120  
8+ 500

 

-500

=         
T17, 200=7, 120 10, 000 900 720 100

So, you can easily find out the Net income of the corporate by calculating,

          Revenues ($900) – Expenses ($720) = Net Income ($180)

That does not seem all that difficult, right? Go over the examples, problems, definitions, and solutions in this blog to get a complete overview of all things related to the fundamental accounting equation. But if you still find them tricky, you can always sign up for online tutorials at leading academic help websites. Good luck with those accounting assignments.

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