Future Business Leaders of America (FBLA) Accounting Practice Test

What is the impact on equity when business expenses exceed revenues?

1. Equity increases

2. Equity decreases

3. Equity stays the same

4. Equity fluctuates

The correct answer is: Equity decreases

When business expenses exceed revenues, the impact on equity is that it decreases. This scenario typically reflects a net loss, which directly affects the equity section of the balance sheet. Equity is essentially the residual interest in the assets of a business after deducting liabilities. When a company incurs expenses that surpass its revenue, it diminishes the overall profitability of the business. This translates to a decrease in retained earnings, which is a significant component of equity. Retained earnings are the cumulative profits that have been reinvested in the business rather than distributed to shareholders as dividends. With higher expenses than income, the business is effectively using up its available resources, which reduces the value of the owners' claim on the assets. Therefore, a net loss resulting from expenses exceeding revenues will directly lower the equity position of the business. This dynamic is crucial for understanding how a business manages its finances and the importance of maintaining a balance between revenues and expenses to ensure positive equity.