Question

Payment of an account payable affects the components of the accounting equation in the following way. a. Decreases owner's equity and decreases liabilities. b. Increases assets and decreases liabilities. c. Decreases assets and increases owner's equity. d. Decreases assets and decreases liabilities.

Short answer

d. Decreases assets and decreases liabilities.

Step-by-step solution

Understand the Scenario

In the exercise, we examine the effect of payment of an account payable on the accounting equation. The accounting equation states that Assets = Liabilities + Owner's Equity. Payment of an account payable typically involves using cash or another asset to settle a liability.

Analyze the Transaction

When an account payable is paid, cash decreases because money is spent to settle the payable. Therefore, assets decrease. The liability, which is the account payable, is also reduced upon payment. Hence, liabilities decrease.

Apply to the Accounting Equation

Based on the transaction, both assets and liabilities decrease. The reduction in assets comes from paying out cash. The reduction in liabilities results from settling the account payable.

Match with Options

From the choices available: - Option a discusses decreases in owner's equity, which is incorrect for this scenario. - Option b mentions an increase in assets, which does not occur. - Option c suggests an increase in owner's equity, which does not occur. - Option d correctly states that both assets and liabilities decrease.

Key concepts

Assets

Assets are essential to a business, representing everything the company owns that has value. They are used to generate revenue and are vital for the daily operation and long-term health of a business. Think of assets like the tools in a toolbox; they are there to help you accomplish your tasks and achieve your goals.

Assets can come in various forms, such as:

• Cash: The most liquid asset, which can be used immediately to settle liabilities.
• Inventory: Goods available for sale, which, when sold, become revenue.
• Property and Equipment: Tangible assets like buildings and machinery used to produce goods or provide services.
• Investments: Financial assets like stocks and bonds that may generate additional income.
• Accounts Receivable: Money owed to the company by customers purchasing goods or services on credit.

When a company uses cash to pay off a liability, this results in a decrease in its assets. This payment directly impacts the accounting equation by reducing the total assets, reflecting the cash outflow.

Liabilities

Liabilities are the obligations a company owes to external parties. They represent debts or other forms of borrowings a business must settle over time. Like a balancing scale, where one side reflects what the company owns, the liabilities side shows what it owes.

Liabilities can be categorized into:

• Accounts Payable: Short-term liabilities indicating money the company owes to suppliers for goods and services purchased on credit.
• Loans and Mortgages: Long-term borrowing that may involve interest payments over several years.
• Accrued Expenses: Costs that have been incurred but not yet paid, such as wages or utilities.

When a liability like an account payable is settled, it decreases. This transaction usually involves paying cash, leading to a simultaneous drop in the asset account. Thus, paying off liabilities directly reduces the obligations listed in the accounting equation, making the company's financial position appear stronger and less leveraged.

Owner's Equity

Owner's equity, often referred to as shareholder's equity, is a critical part of the accounting equation. It represents the owner's claims to the assets after liabilities have been subtracted. Essentially, it reflects what is left for the owner after all debts are paid. Think of it as a snapshot of the company’s net worth.

Owner's equity includes:

• Capital Contributions: Funds that the owner invests into the business, adding to the equity.
• Retained Earnings: Profits that have been reinvested in the business instead of being distributed as dividends.
• Drawings: Withdrawals made by the owner that decrease the equity.

The payment of liabilities, such as an account payable, typically does not affect owner's equity directly. In the specific transaction under discussion, both assets and liabilities decrease. However, since nothing alters the owner's portion of the assets, the owner's equity remains unaffected in this transaction scenario.