What is an Expense?

An expense is like paying for your bus ticket to work...

If you’re working, you need to pay for transportation to go to your office and earn your salary. Those are expenses that are necessary to make money. In the same way, a company needs to spend money on things such as labor, materials, and administration to maintain its business operations.

In common usage, the definition of “expense” is simply money spent on something. But expense has a particular meaning in accounting.

Expenses are the cost of doing business — as it takes money to make money.

Companies are always incurring many different expenses, which can vary depending on their activities. Payments to suppliers, salaries, and equipment depreciation are common expenses incurred by companies.

Companies can deduct expenses on their tax returns to lower their tax if those expenses meet IRS guidelines. This will reduce their tax liability.

There are three main categories of expenses:

1. Operating expenses
2. Non-operating expenses
3. Capital expenses

Operating expenses: Any expenses related to a company’s main activities, such as insurance, sales and marketing, cost of goods sold (COGS), office supplies, rent, repair and maintenance, salary and wages, utilities, and depreciation.

Non-operating expenses: Expenses not related to a business’s core operations, occurring outside day-to-day activities. Interest payments, loss on a sale of an asset, and lawsuit settlement expenses are examples of non-operating expenses.

Capital expenses: When a company purchases physical assets such as buildings or computers; it adds the value of these capital expenditures (CapEx) to its assets. These capital expenditures are often referred to as ‘capital expenses,’ even though that’s a bit of a misnomer. Capital expenditures are carried on the balance sheet, and only their depreciation cost over time shows up as an expense on a company’s income statement (depreciation is an operating expense).

There are two primary accounting methods to record expenses: accrual basis or cash basis. Companies can pick either one but have to use the same method for recording both expenses and revenue.

Accrual basis is the most common method for recording transactions as it typically reflects more accurately a company’s operations for each period.

In the accrual basis method, companies recognize expenses in the period in which they are incurred, not necessarily when they are paid. So, an accrued expense refers to an expense incurred in one accounting period but paid in a different accounting period.

A company that has bought furniture from a supplier, but is waiting for the invoice, is an example.

A company can also pay in advance for goods or services that are expected to be given or used in the future, such as rent paid in advance. In either case, the expense is recognized when it’s ‘used’ (when the furniture is delivered or the month arrives that the rent is for) –- Not when money actually changes hands.

Under cash basis, companies recognize expenses when cash is paid. They only record transactions when there is an exchange of cash. As a result, income may be overstated or understated.

For example, imagine a company has all it’s customers pay cash upfront but pays all it’s suppliers 30 days after an invoice is submitted. If the company orders its materials and supplies in the same month that it sells its products, then it will report all the revenue that month but won’t show the related expenses (material and supply costs) until the next month. This can make that current period seem more profitable than it really was.

People often use the terms “expense” and “cost” interchangeably in conversation, but those two terms don’t exactly have the same meaning in accounting.

A cost typically refers to the spending of money. So depending on what the cost was (what the money is spent on), it may be considered an expense. But this is not always the case.

For instance, when a company purchases an asset like equipment, there is a cost, but there’s generally no expense on the income statement.

Instead, the business will have depreciation expenses over future periods, which is simply showing the reduction of value of the asset over time — There is no ‘cost’ to depreciation (no money changing hands), but an expense is recognized.

A loss can have several different meanings, depending on how it’s used. The general definition of a loss is when expenses are more than revenue. This can be in relation to a single transaction, or the business as a whole.

A capital loss is when a company is selling an asset for a lower price than its purchase price.

Let’s say you own shares and decide to sell them. Imagine those shares cost you $200 when you bought them, and you sold them for $100. You took a loss of $100 on your stock. This is a one-time event and is not related to your business’s core operations so it’s considered a loss, not an expense.

A net loss occurs when total expenses are higher than total revenue. This is the opposite of net profit and is usually recorded at the bottom line of the income statement.

A loss can also refer to a cost that doesn’t relate to normal business operations. For instance, if a company was sued and has to pay out a settlement amount, that would be recognized as a loss, not an expense.

An expense appears on the income statement, whereas assets and liabilities are on the balance sheet. So, an expense is neither an asset nor a liability, and it's offsetting entry could be either... depending on what it is and how it's paid for.

In double-entry bookkeeping, companies record expenses as a debit to a specific expense account. They make corresponding credit entry that will reduce an asset or increase a liability.

For instance, if you pay cash to buy materials, the materials are the expense (shown on the income statement), and the reduction in cash would be shown on the balance sheet as a decrease in your current assets.

An income statement (also called a profit and loss statement) reports a company’s financial performance over a specific accounting period, such as a quarter or a fiscal year. Income statements, like other financial statements, have to follow Generally Accepted Accounting Principles (GAAP) for US companies.

You can find a company’s financial statements on its website or by using EDGAR, a source of financial reports for U.S companies. An income statement generally shows a company’s revenue, expenses, and net income. Here are the main items that an income statement usually lists:

Net sales: Total revenue minus the cost of sales returns, allowances, and discounts.

Cost of goods sold (COGS): Direct costs attributable to the production of products sold.

Selling, general, and administrative expenses (SG&A): Direct and indirect expenses incurred for the promotion, advertising, marketing, and administration of a company.

Extraordinary and special items: Unusual or infrequent events, such as restructuring charges.

Other income and expenses: Income or expenses not related to a business’ core operations.

It then reveals the company’s gross profit, operating income, pre-tax income, and net income. Here is a brief definition for each of these terms:

Gross profit: Net sales minus COGS.

Operating income: Net sales minus operating expenses.

Pre-tax income: Net income before taxes are subtracted.

Net income: Total revenue minus all expenses.

Generally, investors look at the income statement to see if a company is profitable. A company can increase its profit by increasing its revenue or decreasing its expenses.