When a business incurs an expense, the normal reaction to this event is that the amount of profit reported in the income statement has just been reduced. However, the incurrence of an expense also impacts the balance sheet, which is where the ending balances of all classes of assets, liabilities, and equity are reported. The impact of expenses on the balance sheet varies, depending upon the nature of the original expense transaction. The possible variations are:
- Accounts payable. Most expenses are recorded through the accounts payable function, when invoices are received from suppliers. In this case, the accounts payable account is increased, while the amount of the expense reduces the retained earnings account. Thus, the liability portion of the balance sheet increases, while the equity portion declines.
- Accrued expense. When expenses are accrued, this means that an accrued liabilities account is increased, while the amount of the expense reduces the retained earnings account. Thus, the liability portion of the balance sheet increases, while the equity portion declines.
- Cash payment. When an expense is recorded at the same time it is paid for with cash, the cash (asset) account declines, while the amount of the expense reduces the retained earnings account. Thus, there are offsetting declines in the asset and equity sections of the balance sheet.
- Reserve change. The accounting department may elect to increase the size of a reserve, such as the allowance for doubtful accounts or accumulated depreciation. If so, this increases a contra asset account (which is an increase in a credit balance) while reducing the amount of retained earnings (which is a debit transaction). Effectively, the result is an increase in a liability and a reduction of equity.
- Transfer from prepaid expenses. A supplier may have previously been paid in advance for services not yet performed, so the payment was originally recorded in the prepaid expenses (asset) account. When the services are eventually consumed, the amount is charged to expense. The result is a decline in the prepaid expenses (asset) account, and a corresponding decline in the retained earnings account.