An Expense is the cost of operations that a company incurs to generate revenue. As the popular saying goes, “it costs money to make money.” Common expenses include payments to suppliers, employee wages, factory leases, and equipment depreciation. Businesses are allowed to write off tax-deductible expenses on their income tax returns to lower their taxable income and thus their tax liability. However, the Internal Revenue Service (IRS) has strict rules on which expenses business are allowed to claim as a deduction.
Expenses associated with the main activity of the business are referred to as operating expenses. Expenses associated with a peripheral activity are nonoperating or other expenses. For example, a retailer's interest expense is a nonoperating expense. A bank's interest expense is an operating expense. Generally, expenses are debited to a specific expense account and the normal balance of an expense account is a debit balance. When an expense account is debited, the account credited might be Cash (if cash was paid at the time of the expense), Accounts Payable (if cash will be paid after the expense is recorded), or Prepaid Expense (if cash was paid before the expense was recorded.)
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:
- 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 manufacturing firms, COGS includes direct labor, direct materials, and manufacturing overhead.
- 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.
- 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.
- 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.
- 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.
- 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:
- A debit to a depreciation expense account and a credit to a contra asset account called accumulated depreciation
- On the balance sheet, the book value of the asset is decreased by the accumulated depreciation.
Expenses are income statement accounts that are debited to an account, and the corresponding credit is booked to a contra asset or liability account.
An expense report is a form of document that contains all the expenses that an individual has incurred as a result of the business operation. For example, if the owner of a business travels to another location for a meeting, the cost of travel, the meals, and all other expenses that he/she has incurred may be added to the expense report. Consequently, these expenses will be considered business expenses and are tax-deductible.
Many businesses benefit from automated expense reports systems for expense management. Depending on the system chosen, these software solutions can reduce time costs, errors, and fraud.