Virginia Contractor General Practice Test

How is equity calculated in financial accounting?

1. Assets + Liabilities

2. Assets - Liabilities

3. Assets / Liabilities

4. Assets x Liabilities

The correct answer is: Assets - Liabilities

In financial accounting, equity represents the owner's residual interest in the assets after deducting liabilities. This relationship is central to the accounting equation, which is articulated as: Assets = Liabilities + Equity. Rearranging this equation to solve for equity results in the formula Equity = Assets - Liabilities. Thus, to determine equity, you subtract total liabilities from total assets. This calculation helps in understanding the net worth of an individual or a business, demonstrating how much of the company's assets are owned free and clear of debts. It is a key measure for investors and management, reflecting the financial health of an entity and its ability to cover obligations. The other methods mentioned do not accurately represent how equity is calculated. Adding assets and liabilities would not provide meaningful insight into ownership interest, while dividing or multiplying these figures isn't relevant in this context. This clarity underscores why the subtraction of liabilities from assets is the correct approach to calculating equity.