Impact of Expenses on the Balance Sheet
Expenses affect the balance sheet indirectly through the income statement and the statement of retained earnings. Here’s how it works:
- Reduction in net income: When a company incurs an expense, it will decrease net income on the income statement because expenses are deducted from revenues.
- Impact on retained earnings: The decrease in net income leads to a decrease in retained earnings in the statement of retained earnings. Retained earnings is the portion of net income which is retained by the corporation rather than distributed to its owners as dividends. So, when net income decreases, retained earnings also decrease.
- Decrease in owner’s equity: Retained earnings are part of owner’s equity (or shareholder’s equity for corporations) on the balance sheet. Therefore, when retained earnings decrease due to an increase in expenses, owner’s equity also decreases.
- Changes in assets or liabilities: Depending on the nature of the expense, there could be a direct impact on the assets or liabilities. For instance, if an expense is paid for in cash, there will be a decrease in cash, an asset account. If the expense is incurred but not yet paid, it will increase liabilities in the form of accounts payable or accrued expenses.
So, while expenses don’t appear directly on the balance sheet, they can have significant effects on the various components of the balance sheet, including assets, liabilities, and owner’s equity, mainly by reducing net income and retained earnings.
Example of the Impact of Expenses on the Balance Sheet
Let’s consider an example of a company, ABC Corp. At the beginning of the year, the company’s balance sheet might look something like this:
Assets:
- Cash: $10,000
- Inventory: $5,000
- Total Assets: $15,000
Liabilities:
- Accounts Payable: $2,000
- Total Liabilities: $2,000
Owner’s Equity:
- Retained Earnings: $5,000
- Capital Stock: $8,000
- Total Owner’s Equity: $13,000
Now, let’s assume that ABC Corp incurs an expense of $3,000 for rent that it pays in cash. Here’s how the expense would impact the balance sheet:
- The cash payment of $3,000 will decrease the Cash account under Assets. So, the new Cash balance will be $7,000 ($10,000 – $3,000).
- This expense will also decrease net income. Assuming there are no other revenues or expenses, the net income would be -$3,000.
- This decrease in net income reduces Retained Earnings in the Owner’s Equity section of the balance sheet. So, the new Retained Earnings will be $2,000 ($5,000 – $3,000).
- Since Retained Earnings decrease, Total Owner’s Equity also decreases to $10,000 ($2,000 + $8,000).
So, the new balance sheet after recognizing the expense will look like this:
Assets:
- Cash: $7,000
- Inventory: $5,000
- Total Assets: $12,000
Liabilities:
- Accounts Payable: $2,000
- Total Liabilities: $2,000
Owner’s Equity:
- Retained Earnings: $2,000
- Capital Stock: $8,000
- Total Owner’s Equity: $10,000
As you can see, the expense has led to a decrease in assets (Cash) and owner’s equity (Retained Earnings and Total Owner’s Equity). The balance sheet remains in balance, with total assets equaling total liabilities plus owner’s equity.
