An expense in accounting is the money spent, or costs incurred, by a business in their effort to generate revenues. Essentially, accounts expenses represent the cost of doing business; they are the sum of all the activities that hopefully generate a profit.
It is important to understand the difference between “cost” and “expense” since they each have a distinct meaning in accounting. Cost is the monetary measure (cash) that has been given up in order to buy an asset. An expense is a cost that has expired or been taken up by activities that help generate revenue. Therefore, all expenses are costs, but not all costs are expenses.
What is an Expense?
An expense is defined in the following ways:
Office supplies use up the cash (asset)
Depreciation expense, which is a charge to reduce the book value of capital equipment (e.g., a machine or a building) to reflect its usage over a period.
A prepaid expense, such as prepaid rent, is an asset that turns into a cash expense as the rent is used up each month
A summary of all expenses is included in the income statement as deductions from the total revenue. Revenue minus expenses equals the total net profit of a company for a given period.
In the double-entry bookkeeping system, expenses are one of the five main groups where financial transactions are categorized. Other categories include the owner’s equity, assets, liabilities, and revenue. Expenses in double-entry bookkeeping are recorded as a debit to a specific expense account. A corresponding credit entry is made that will reduce an asset or increase a liability.
The purchase of an asset such as land or equipment is not considered a simple expense but rather a capital expenditure. Assets are expensed throughout their useful life through depreciation and amortization.
Expenses in Cash Accounting and Accrual Accounting
Expenses are recorded in the books on the basis of the accounting system chosen by the business, either through an accrual basis or a cash basis. Under the accrual method, the expense for the good or service is recorded when the legal obligation is complete; that is when the goods have been received or the service has been performed.
Under cash accounting, the expense is only recorded when the actual cash has been paid. For example, a utility expense incurred in April but paid in May will be recorded as an expense in April under the accrual method but recorded as an expense in May under the cash method – as this is when the cash is actually paid.
Accrual accounting is based on the matching principle that ensures that accurate profits are reflected for every accounting period. The revenue for each period is matched to the expenses incurred in earning that revenue during the same accounting period. For example, sale commission expenses will be recorded in the period that the related sales are reported, regardless of when the commission was actually paid.
Types of Expenses
Expenses affect all financial accounting statements but exert the most impact on the income statement. They appear on the income statement under five major headings, as listed below:
1. Cost of Goods Sold (COGS)
Cost of Goods Sold (COGS) is the cost of acquiring raw materials and turning them into finished products. It does not include selling and administrative costs incurred by the whole company, nor interest expense or losses on extraordinary items.
For a service company, it is called a cost of services rather than COGS.
For a company that sells both goods and services, it is called cost of sales.
Examples of COGS include direct material, direct costs, and production overhead.
2. Operating Expenses – Selling/General and Admin
Operating expenses are related to selling goods and services and include sales salaries, advertising, and shop rent.
General and administrative expenses include expenses incurred while running the core line of the business and include executive salaries, R&D, travel and training, and IT expenses.
3. Financial Expenses
They are costs incurred from borrowing from lenders or creditors. They are expenses outside the company’s core business. Examples include loan origination fees and interest on money borrowed.
4. Extraordinary Expenses
Extraordinary expenses are costs incurred for large one-time events or transactions outside the firm’s regular business activity. They include laying off employees, selling land, or disposal of a significant asset.
5. Non-Operating Expenses
These are costs that cannot be linked back to operating revenues. Interest expense is the most common non-operating expense. Interest is the cost of borrowing money. Loans from banks usually require interest payments, but such payments don’t generate any operating income. Hence, they are classified as non-operating expenses.
Under the accrual method of accounting, non-cash expenses are those expenses that are recorded in the income statement but do not involve an actual cash transaction. Depreciation is the most common type of non-cash expense, as it reduces net profit, but is not a result of a cash outflow. The accounting transaction and its impact on the financial statements are outlined below.: