What is the effect of expenses on retained earnings?

• A. Expenses decrease retained earnings.
• B. Expenses are recorded directly as assets, not affecting retained earnings.
• C. Expenses increase retained earnings.
• D. Expenses have no effect on retained earnings.

Answer: (A)

Verified step by step guidance

1. Understand the relationship between expenses and retained earnings: Retained earnings represent the accumulated net income of a company that has not been distributed as dividends. Expenses reduce net income, which in turn reduces retained earnings.
2. Recall the formula for retained earnings: Retained Earnings = Beginning Retained Earnings + Net Income - Dividends. Since expenses reduce net income, they indirectly decrease retained earnings.
3. Recognize how expenses are recorded: Expenses are recorded on the income statement and reduce net income. They are not recorded as assets, as assets represent resources owned by the company, while expenses represent costs incurred.
4. Eliminate incorrect options: Expenses do not increase retained earnings, nor do they have no effect on retained earnings. These options contradict the fundamental accounting principles.
5. Conclude the correct answer: Expenses decrease retained earnings because they reduce net income, which is a component of retained earnings.