# Liabilities and Equity

Business I · Accounting I · https://tryals.app/learn/business-i/liabilities-and-equity

## The Right Side of the Equation

Liabilities and equity answer **who financed the assets?** The distinction is legal: **creditors** hold a fixed claim, while **owners** hold a residual claim.

| | Creditors (liabilities) | Owners (equity) |
|---|---|---||
| Claim | Fixed, contractual | Residual, flexible |
| Payment | Due on schedule | Discretionary dividends |
| Failure | Paid first | Paid last |
| Upside | Capped | Unlimited |

**Current liabilities** are obligations due within one year. **Trade payables** are owed to suppliers for goods. **Accrued expenses** are incurred costs like unpaid wages. **Unearned revenue** is cash received before delivery—a liability because you still owe the service.

## Debt, Equity, and Capital Structure

**Non-current liabilities** are due beyond one year, including **bonds payable**, **lease liabilities**, and **deferred tax liabilities**. **Equity** is the owners' stake, defined as $\text{Equity} = \text{Share capital} + \text{Retained earnings} + \text{Reserves}$.

**Share capital** is cash invested by owners. **Share premium** is excess over par value. **Retained earnings** is cumulative profit minus dividends.

**Capital structure decision**: More debt increases fixed risk but amplifies returns. More equity lowers risk but dilutes control.

## Practice questions

8 of this lesson's 13 practice questions, with answers. The full set is in the app.

### 1. Current liability, non-current liability, or equity?

**Answer:**

- Current liability: Trade payables due in 30 days, Wages accrued but not yet paid
- Non-current liability: A ten-year corporate bond, A pension obligation
- Equity: Retained earnings, Share premium

**Why:** Current = due within a year. Non-current = beyond a year. Equity = the owners' residual. The three buckets exhaust the right side of the equation.

Page: https://tryals.app/practice/business-i/liabilities-and-equity/current-liability-non-current-liability-or-equity

### 2. Match each right-side item to its nature.

**Answer:**

- Unearned revenue → Cash received for services not yet delivered
- Retained earnings → Cumulative profits left inside the firm
- Deferred tax → Tax owed but not yet due
- Share capital → What owners invested

**Why:** Unearned revenue is a liability (you owe the service). Retained earnings are equity (owners' accumulated profit). Deferred tax is a timing liability. Share capital is the owners' injection.

Page: https://tryals.app/practice/business-i/liabilities-and-equity/match-each-right-side-item-to-its-nature

### 3. Retained earnings sit at 4 million and the bank account holds 200,000. Where did the rest go?

A. The two figures should match, so there is a bookkeeping error
B. Into other assets: inventory, equipment, receivables
C. It was paid out as dividends over the years
D. It was consumed by losses in earlier periods

**Answer:** B. Into other assets: inventory, equipment, receivables

**Why:** Retained earnings are a claim figure on the financing side, and the assets side records what the money was turned into, a factory, mostly. Reading it as a cash reserve is the classic misinterpretation, and it is why a profitable firm can have a large retained-earnings balance and no ability to pay a dividend.

Page: https://tryals.app/practice/business-i/liabilities-and-equity/retained-earnings-sit-at-4-million-and-the-bank-account-holds

### 4. A firm has been profitable for years but has never paid a dividend. Where does all that profit sit?

A. In revenue, which grows each year
B. In retained earnings, within equity
C. In a secret cash reserve outside the balance sheet
D. Nowhere, profit disappears after the income statement is prepared

**Answer:** B. In retained earnings, within equity

**Why:** Net profit flows into retained earnings at each closing. Retained earnings is the cumulative total of all profits ever earned minus all dividends ever paid, the firm's internal financing history.

Page: https://tryals.app/practice/business-i/liabilities-and-equity/a-firm-has-been-profitable-for-years-but-has-never-paid-a-dividend

### 5. Which are advantages of debt financing over equity financing?

A. No obligation to make payments
B. Lower risk of financial distress
C. Interest is tax-deductible, creating a tax shield
D. No ownership dilution for existing shareholders

**Answer:** C. Interest is tax-deductible, creating a tax shield; D. No ownership dilution for existing shareholders

**Why:** Debt offers tax shields and avoids dilution, but at the cost of fixed obligations and higher distress risk. Options 3 and 4 are equity's advantages, not debt's.

Page: https://tryals.app/practice/business-i/liabilities-and-equity/which-are-advantages-of-debt-financing-over-equity-financing

### 6. A firm receives €12,000 for a year of service not yet delivered. Why is unearned revenue a liability when the cash has already arrived?

A. Because it becomes equity only after the service is delivered
B. Because the obligation to deliver the service has been created
C. Because revenue cannot be recognised until the cash clears the bank
D. Because the cash might have to be refunded if the customer complains

**Answer:** B. Because the obligation to deliver the service has been created

**Why:** Cash arriving creates an asset and an obligation at once. Recognising revenue immediately would report profit for work not yet done, which is exactly the manipulation the rule prevents.

Page: https://tryals.app/practice/business-i/liabilities-and-equity/a-firm-receives-12-000-for-a-year-of-service-not-yet-delivered-why

### 7. Order the steps of issuing a corporate bond.

**Answer:**

1. The firm decides it needs long-term financing
2. Bond terms are set: face value, coupon rate, maturity
3. Investors buy the bonds, cash arrives
4. Semi-annual coupon payments are made to bondholders
5. At maturity, the face value is repaid

**Why:** Need, structure, issuance, periodic interest, repayment, the lifecycle of a bond from the issuer's perspective.

Page: https://tryals.app/practice/business-i/liabilities-and-equity/order-the-steps-of-issuing-a-corporate-bond

### 8. A firm has total equity 300 and total liabilities 600. **Estimate the debt-to-equity ratio.**

**Answer:** 2 (within ±0.2)

**Why:** $600 / 300 = 2.0$. For every euro of owners' money, two euros of creditor money, a leveraged structure that amplifies both gains and risks.

Page: https://tryals.app/practice/business-i/liabilities-and-equity/a-firm-has-total-equity-300-and-total-liabilities-600-estimate-the