According to the fundamental accounting equation, if a company capitalizes tools with a purchase price greater than \$1,000, which of the following is the correct effect on the company's financial statements at the time of purchase?

• A. Expenses increase; assets remain unchanged.
• B. Assets decrease; equity increases.
• C. Liabilities increase; equity decreases.
• D. Assets increase; liabilities or cash decrease by the purchase amount.

Answer: (D)

Verified step by step guidance

1. Understand the fundamental accounting equation: Assets = Liabilities + Equity. This equation must always remain balanced.
2. Recognize that capitalizing tools means recording them as assets rather than expenses. This increases the company's assets because the tools are now part of the company's resources.
3. Determine how the purchase is financed. If the tools are purchased with cash, the cash account (an asset) decreases by the purchase amount. If financed through credit, liabilities increase by the purchase amount.
4. Analyze the impact on equity. At the time of purchase, equity remains unchanged because the transaction does not directly affect retained earnings or contributed capital.
5. Conclude that the correct effect on the financial statements is: Assets increase by the value of the tools, and either liabilities increase or cash decreases by the purchase amount, ensuring the accounting equation remains balanced.