Which of the following statements correctly describes how expenses affect equity?

• A. Expenses increase assets and therefore increase equity.
• B. Expenses increase equity by generating revenue.
• C. Expenses have no effect on equity.
• D. Expenses decrease equity by reducing net income.

Answer: (D)

Verified step by step guidance

1. Understand the relationship between expenses and equity: Equity represents the owner's claim on the assets of the business, and it is affected by net income. Net income is calculated as revenues minus expenses.
2. Recognize that expenses reduce net income: When a business incurs expenses, it decreases the amount of net income available. Lower net income directly impacts equity because net income contributes to retained earnings, which is a component of equity.
3. Analyze the incorrect statements: The first statement is incorrect because expenses do not increase assets or equity; they reduce net income. The second statement is incorrect because expenses do not increase equity; they reduce it. The third statement is incorrect because expenses do have an effect on equity by reducing it.
4. Identify the correct statement: The correct statement is 'Expenses decrease equity by reducing net income.' This is because expenses lower the profitability of the business, which in turn reduces the retained earnings portion of equity.
5. Summarize the concept: Expenses are subtracted from revenues to calculate net income. A decrease in net income leads to a decrease in retained earnings, which ultimately reduces equity.