Which of the following statements best describes the effect of expenses on equity according to the fundamental accounting equation?

• A. Expenses decrease equity because they reduce net income.
• B. Expenses have no effect on equity.
• C. Expenses increase both assets and equity.
• D. Expenses increase equity because they are investments in the business.

Answer: (A)

Verified step by step guidance

1. Understand the fundamental accounting equation: Assets = Liabilities + Equity. Equity represents the owner's residual interest in the business after liabilities are subtracted from assets.
2. Recognize that net income is a component of equity. Net income is calculated as Revenues - Expenses. Therefore, expenses directly impact net income, which in turn affects equity.
3. Analyze the relationship between expenses and equity: When expenses increase, they reduce net income. A reduction in net income leads to a decrease in equity.
4. Evaluate the incorrect options: Expenses do not increase equity because they are not investments; they represent costs incurred to generate revenue. Expenses also do not increase both assets and equity, nor do they have no effect on equity.
5. Conclude that the correct statement is: 'Expenses decrease equity because they reduce net income.' This aligns with the fundamental accounting equation and the relationship between expenses, net income, and equity.