MCQ on Accounting Equations and Company’s Income

Statement
1. How does retaining profits in a business support growth?

a) By increasing cash distributions

b) By reinvesting profits in assets like land, buildings, or inventory
c) By reducing shareholder equity
d) By taking additional loans
Answer: b) By reinvesting profits in assets like land, buildings, or
inventory
Justification: Retained profits are reinvested into assets that help the
business expand operations and increase sales. For example, a company
might use profits to purchase new machinery, enhancing production
capacity.

2. What happens if profits are reinvested in non-cash assets?

a) They become immediately available as cash

b) They contribute to growth but reduce immediate cash availability
c) They decrease total equity
d) They increase liabilities
Answer: b) They contribute to growth but reduce immediate cash
availability
Justification: Profits used to acquire inventory, equipment, or land
enhance future earning potential but reduce liquidity. For instance,
buying $100,000 of inventory ties up cash in assets.

3. What ensures that the accounting equation remains balanced

during profitable operations?
a) Total liabilities always increase
b) Total equity increases without affecting assets
c) Any increase in equity is matched by changes in assets or liabilities
d) Only liabilities decrease
Answer: c) Any increase in equity is matched by changes in assets or
liabilities
Justification: Profits (equity) must reflect in either increased assets
(e.g., cash) or reduced liabilities. For instance, a $50,000 net profit might
increase cash (an asset) or repay debt.

4. Why might a company choose not to distribute profits as

dividends?

a) To reduce liabilities
b) To conserve cash for reinvestment in business operations
c) To increase liabilities
d) To pay off shareholders directly
Answer: b) To conserve cash for reinvestment in business operations
Justification: Companies prioritize growth and reinvest retained
earnings into new projects. For example, a tech startup might reinvest all
profits into R&D instead of paying dividends.

5. What determines whether a company can distribute profits to

shareholders?

a) The total increase in liabilities

b) The sufficiency of cash available
c) The amount of retained earnings
d) The company’s inventory levels
Answer: b) The sufficiency of cash available
Justification: Even with high profits, a company with low cash may
struggle to pay dividends. For example, a company might have $200,000
in profits but only $5,000 in cash due to reinvestment.

6. How does repaying a loan affect the accounting equation?

a) It increases liabilities and decreases equity

b) It decreases liabilities and increases equity
c) It decreases equity without affecting assets
d) It only decreases liabilities
Answer: b) It decreases liabilities and increases equity
Justification: Loan repayment reduces liabilities and increases equity
by reflecting improved financial health. For example, repaying a
$10,000 loan reduces both liabilities and cash (an asset).

7. What does the term "comprehensive income" encompass in

financial reporting?

a) Only profits available for distribution

b) Earnings retained and reinvested in the business
c) Total changes in equity excluding owner contributions and
distributions
d) Total liabilities of the company
Answer: c) Total changes in equity excluding owner contributions and
distributions
Justification: Comprehensive income includes net income and other
gains (e.g., unrealized gains). For instance, a $5,000 unrealized gain in
investments adds to equity without involving contributions.

8. How might a company’s decision to invest profits in inventory

affect its financial position?
a) It reduces liabilities without affecting equity
b) It increases total assets but reduces cash availability
c) It decreases total assets and equity
d) It does not affect the accounting equation
Answer: b) It increases total assets but reduces cash availability
Justification: Investing in inventory reallocates cash into assets,
keeping the equation balanced. For example, $20,000 spent on inventory
increases inventory assets but reduces cash.

9. What is a critical consideration for understanding retained

earnings?

a) Retained earnings are always held in cash

b) Retained earnings can be tied up in non-liquid assets
c) Retained earnings are not affected by profitability
d) Retained earnings must be distributed as dividends
Answer: b) Retained earnings can be tied up in non-liquid assets
Justification: Retained earnings may be reinvested in assets like
equipment. For example, a company might retain $100,000 of earnings
but use it to buy a new building, reducing cash.

10. Why is an increase in equity not always immediately accessible

for shareholder distribution?

a) Because equity is offset by a decrease in liabilities

b) Because earnings may be reinvested in long-term assets
c) Because equity represents only liabilities
d) Because all earnings are distributed as dividends
Answer: b) Because earnings may be reinvested in long-term assets
Justification: Reinvesting profits in equipment or expansion reduces
cash. For example, $50,000 of profit used for machinery cannot be
distributed as dividends.

11. How can a profitable operation reduce liabilities without

changing total assets?

a) By paying down loans using existing cash

b) By reinvesting profits into new assets
c) By increasing inventory
d) By issuing new debt
Answer: a) By paying down loans using existing cash
Justification: Loan repayment reduces liabilities while cash (an asset)
decreases by the same amount. For example, repaying a $5,000 loan
reduces both liabilities and cash by $5,000.

12. What happens if a company distributes dividends from

insufficient cash?

a) Total equity remains unchanged

b) The Company may need to take on debt to fund distributions
c) Retained earnings decrease without affecting cash flow
d) Shareholder equity increases
Answer: b) The company may need to take on debt to fund distributions
Justification: Without sufficient cash, a company might borrow to
maintain dividends. For instance, $20,000 in declared dividends but only
$10,000 in cash might require borrowing.

13. What is a potential downside of reinvesting all profits into non-

liquid assets?
a) Increased liabilities
b) Reduced cash flexibility for short-term obligations
c) Decreased shareholder equity
d) Overstated profits
Answer: b) Reduced cash flexibility for short-term obligations
Justification: Excessive reinvestment leaves little cash for day-to-day
needs. For example, using all $100,000 of profits for land purchase may
create cash flow issues.

14. How does the distribution of dividends affect the accounting

equation?

a) Reduces equity and cash

b) Reduces liabilities and cash
c) Increases equity and reduces cash
d) Reduces assets without affecting equity
Answer: a) Reduces equity and cash
Justification: Dividend payouts reduce retained earnings (equity) and
cash. For example, paying $15,000 in dividends reduces cash and equity
equally.

15. How can equity increase even if cash decreases?

a) By acquiring new liabilities

b) By reinvesting in profitable assets
c) By recording unrealized gains in non-cash assets
d) By issuing new debt
Answer: c) By recording unrealized gains in non-cash assets
Justification: Gains in investments or property valuation increase
equity. For instance, a $50,000 increase in property value adds to equity
without cash involvement.
16. Why is equity a better indicator of financial health than
liabilities?

a) Equity represents ownership in assets after liabilities are paid

b) Equity excludes comprehensive income
c) Liabilities are irrelevant in the accounting equation
d) Equity reflects only cash inflows
Answer: a) Equity represents ownership in assets after liabilities are
paid
Justification: Equity shows what shareholders would receive after
settling debts. For instance, a company with $1M in assets and $400K in
liabilities has $600K equity.

17. How does reinvestment of profits in equipment impact

depreciation?

a) Increases immediate expenses and reduces future profits

b) Reduces total equity
c) Only affects liabilities
d) Has no financial impact
Answer: a) Increases immediate expenses and reduces future profits
Justification: Equipment purchase leads to depreciation, which reduces
taxable income over time. For example, a $50,000 machine with $5,000
yearly depreciation reduces annual profits.

18. What happens if retained earnings exceed total equity?

a) Total liabilities must decrease

b) Retained earnings cannot exceed equity
c) The company is overvalued
d) The company is under significant debt
Answer: b) Retained earnings cannot exceed equity
Justification: Retained earnings are a subset of equity, and the balance
sheet equation ensures this.

19. Can reinvestment in inventory increase liabilities?

a) Yes, if inventory is purchased on credit

b) No, as it only affects cash
c) Yes, because equity always decreases
d) No, as liabilities are unaffected by profits
Answer: a) Yes, if inventory is purchased on credit
Justification: Buying $30,000 inventory on credit increases inventory
(assets) and accounts payable (liabilities).

20. What drives a company’s decision to retain versus distribute

profits?

a) Shareholder demand
b) Liquidity needs and growth strategy
c) Regulatory obligations
d) The Company’s debt level
Answer: b) Liquidity needs and growth strategy
Justification: Companies retain earnings to invest in growth but
distribute when cash and obligations permit.
 MCQs on Net Income and Comprehensive Income

1. Which of the following accurately distinguishes between net

income and other comprehensive income?

a) Net income affects the balance sheet, but other comprehensive income
does not.
b) Net income is reported in the income statement, whereas other
comprehensive income is reported directly in equity.
c) Net income impacts retained earnings, but other comprehensive
income impacts cash flow.
d) Both net income and other comprehensive income are reported under
retained earnings.
Answer: b) Net income is reported in the income statement, whereas
other comprehensive income is reported directly in equity.
Justification: Net income appears in the income statement and is
transferred to retained earnings. Other comprehensive income affects
equity via the AOCI account but bypasses the income statement.

2. How does an increase in "other comprehensive income" affect

total equity?

a) It decreases total liabilities.

b) It directly increases retained earnings.
c) It increases total equity via the AOCI account.
d) It is neutral to equity changes.
Answer: c) It increases total equity via the AOCI account.
Justification: Other comprehensive income items, although excluded
from net income, increase total equity directly through the AOCI
account.
3. Which of these is not a component of other comprehensive
income?

a) Foreign currency translation adjustments

b) Unrealized gains on available-for-sale securities
c) Net income from operations
d) Actuarial gains and losses on defined benefit plans
Answer: c) Net income from operations
Justification: Net income is reported in the income statement, not under
other comprehensive income.

4. Why are some revenues and expenses classified under other

comprehensive income instead of net income?

a) To reduce tax obligations

b) They are considered irrelevant to operating results
c) They are mandated by accounting standards to exclude operational
impacts
d) They are offset by liabilities
Answer: c) They are mandated by accounting standards to exclude
operational impacts
Justification: Items in other comprehensive income are excluded from
net income because they do not represent core operating performance
and are governed by accounting standards.

5. What happens to net income at the end of the accounting period?

a) It is transferred to retained earnings in equity.

b) It is directly recorded in the AOCI account.
c) It is carried forward to the next income statement.
d) It is deducted from total equity.
Answer: a) It is transferred to retained earnings in equity.
Justification: Net income is transferred to the retained earnings account
within the equity section during the year-end closing.

6. If a company reports a net loss, how does it impact the balance

sheet?

a) It decreases liabilities.
b) It increases the AOCI balance.
c) It decreases retained earnings in the equity section.
d) It does not affect the balance sheet.
Answer: c) It decreases retained earnings in the equity section.
Justification: Net loss reduces total equity by directly lowering the
retained earnings balance.

7. Which account does not contribute to the equity section of the

balance sheet?

a) Retained earnings
b) Accumulated Other Comprehensive Income (AOCI)
c) Treasury stock
d) Accounts receivable
Answer: d) Accounts receivable
Justification: Accounts receivable is a current asset, not a part of equity.

8. Why are AOCI items not included in net income?

a) They are non-operational and reflect broader economic factors.

b) They directly reduce liabilities.
c) They are considered losses only.
d) They are speculative and do not follow accounting standards.
Answer: a) They are non-operational and reflect broader economic
factors.
Justification: Items in AOCI represent gains or losses not tied to regular
operations and provide a clearer separation of operational versus non-
operational impacts.

9. Which scenario would result in an adjustment to the AOCI

account?

a) A sale of inventory at a profit

b) A change in the fair value of hedging instruments
c) A dividend declaration
d) A repayment of a loan
Answer: b) A change in the fair value of hedging instruments
Justification: Gains or losses from hedging instruments are part of other
comprehensive income and directly adjust the AOCI account.

10. Which financial statement provides details of other

comprehensive income?

a) Balance sheet
b) Income statement
c) Statement of comprehensive income
d) Statement of retained earnings
Answer: c) Statement of comprehensive income
Justification: Other comprehensive income is detailed in the statement
of comprehensive income, which complements the income statement.

11. Which items in AOCI can directly impact future retained

earnings?
a) Depreciation adjustments
b) Realized gains previously recorded in AOCI
c) Capital contributions
d) Unrealized gains on property
Answer: b) Realized gains previously recorded in AOCI
Justification: When gains or losses previously reported in AOCI are
realized, they flow into net income and subsequently affect retained
earnings.

12. What would happen if other comprehensive income were

included in net income?

a) Equity would remain unaffected.

b) Financial performance metrics would be distorted.
c) AOCI balances would be overstated.
d) There would be no difference.
Answer: b) Financial performance metrics would be distorted.
Justification: Including AOCI in net income would blur the distinction
between core operational performance and other economic factors.

13. How is the AOCI account presented in the balance sheet?

a) As part of current liabilities

b) Under the retained earnings subsection
c) In a separate subsection of equity
d) As an intangible asset
Answer: c) In a separate subsection of equity
Justification: The AOCI account is presented in the equity section,
separate from retained earnings.
14. If unrealized losses in AOCI exceed gains, what is the net
impact?

a) Total equity decreases.

b) Retained earnings are unaffected.
c) Liabilities increase.
d) Assets decrease.
Answer: a) Total equity decreases.
Justification: Unrealized losses lower the total AOCI balance, reducing
total equity.

15. Why is comprehensive income a better measure of total equity

changes than net income?

a) It includes operational changes only.

b) It reflects all changes in equity, including non-owner transactions.
c) It excludes operational performance.
d) It only considers cash-based transactions.
Answer: b) It reflects all changes in equity, including non-owner
transactions.
Justification: Comprehensive income captures both net income and
AOCI, representing total equity changes from all non-owner activities.

16. What is the primary purpose of separating net income and other
comprehensive income?

a) To comply with auditing requirements

b) To clarify the impact of core operations versus other factors
c) To reduce tax liabilities
d) To avoid overstating revenues
Answer: b) To clarify the impact of core operations versus other factors
Justification: Separating the two provides transparency on the
operational and non-operational aspects of performance.

17. When does an item in AOCI move to net income?

a) When it is realized or settled

b) At the end of every accounting period
c) During a cash flow adjustment
d) Never
Answer: a) When it is realized or settled
Justification: Realized items from AOCI are transferred to net income
as they represent actual gains or losses.

18. How do unrealized gains affect AOCI?

a) They increase liabilities.

b) They increase the AOCI balance, which adds to equity.
c) They reduce retained earnings.
d) They remain neutral to equity changes.
Answer: b) They increase the AOCI balance, which adds to equity.
Justification: Unrealized gains are reported in AOCI, directly boosting
equity.

19. How does the reporting of AOCI align with accounting

principles?

a) It ensures cash-based accounting.

b) It complies with the accrual principle and fair value reporting.
c) It avoids matching revenues with expenses.
d) It prevents disclosure of unrealized amounts.
Answer: b) It complies with the accrual principle and fair value
reporting.
Justification: AOCI reflects accrual-based accounting and fair value
adjustments for items like securities and currency.

20. What role does AOCI play in financial analysis?

a) It affects the cost of capital calculation.

b) It shows potential future impacts on earnings.
c) It directly influences cash flow decisions.
d) It determines liability structures.
Answer: b) It shows potential future impacts on earnings.
Justification: AOCI items often signal future earnings changes when
unrealized gains/losses are realized.