Many people—even businesspeople—use the terms expense and expenditure more or less interchangeably. To the firm's accountants and budgeting specialists, however, the terms are not synonymous. Expense is just one of four kinds of spending actions that qualify as expenditures.
Explaining Expenditure in Context
Sections below further explain and illustrate expenditure, in context with relevant terms from accounting, budgeting, and finance.
Businesspeople use quite a few different terms referring to payments and spending obligations. Many, however, confuse different spending terms or use them interchangeably when they are not truly synonyms and are not interchangeable. Some, for instance, see the terms expensive and costly as meaning the same thing. And, many make little distinction between the terms expense, expenditure, and cost.
These terms all have different meanings in business, however. While there may be no harm in confusing these terms in everyday conversation, those responsible for business planning, budgeting, and financial accounting need to understand precisely the meaning of each.
Exhibit 1 below shows that the broadest or most inclusive of these terms is cost. All of the terms in light blue and yellow cells are, arguably, costs.
Cost and Costing in Accounting
To accountants, cost primarily means an amount of money that firms give up or pay out to acquire something, usually goods or services. The name of an accounting activity, cost accounting, is an example of this usage.
In cost accounting, accountants use the term cost object to refer to any item having a cost figure of its own. The term applies to a very wide range of items, which accountants "cost" by estimation, by direct measurement, or by allocation or apportionment. Cost object items may include, for instance:
- Services (such as consulting services with a definite cost).
- Goods (such as raw materials for producing products).
- Products (e.g., a product whose costs of design, development, and production are specified).
- Projects (e.g., a product design project).
- Rights, such as the right to use a patent or a license to operate a business.
- Customers (customers are cost object when there is a cost of selling or service delivery ).
- Contracts (such as a product warranty support contract, when contract and service delivery have definite costs).
- Resources (e.g., fuel for operating vehicles).
- Activities (such as using a vehicle to deliver goods).
Defining Cost Broadly
However, businesspeople also use the term cost widely—and appropriately—when referring to other kinds of losses or negative impacts, including nonfinancial negative impacts. Management may say, for example, that a recent pay freeze has "cost the company dearly in terms of lower employee morale." Or, marketers may say that the company is paying a heavy cost in terms of brand image damage, due to poor product quality.
In other words, under the broader definition, "cost" can simply mean "negative impact," whether financial or nonfinancial..
Exhibit 1 below recognizes both the broader meaning of cost as well as the accountant's narrower definition.
What is the Meaning of Sunk Cost?
A sunk cost is a cost that has already been incurred and is not recoverable. Businesspeople are sometimes unwilling to "walk away" from sunk costs and sometimes need reminding that sunk costs are usually not relevant for decisions about present or future alternatives. Two well-known phrases capture the sense in which financial professionals generally view sunk costs:
- "It's water under the bridge"
- "Don’t throw good money after bad."
Some businesspeople still prefer to consider sunk costs when making decisions about future actions. To them, it may seem at first that disregarding sunk costs is abandoning funds already invested.
However, the cold, rational view is that sunk costs should have no relevance for the decision or choice under consideration. This view is legitimate because sunk costs are now "history," and will not change no matter which decision option prevails for the future. For this reason, sunk costs do not belong in a forward-looking business case analysis, when the analysis provides decision support for recommending a future course of action.
An expenditure is spending activity the firm pays with cash or cash equivalents. Expenditures serve at least four different purposes:
- Firstly, to acquire an asset.
- Secondly, to distribute funds to owners (e.g., through drawing accounts).
- Thirdly, to reduce a liability (e.g., pay off a loan)
- Fourthly, as an expense.
Expense: A decrease in owner’s equity due to using up assets.
Two Kinds of Expense Categories
Expenses belong to two kinds of expense categories:
Firstly, expenses are either operating expenses or non-operating expenses.
- Employee wages and salaries, for instance, are operating expenses because they support operations in the firm's normal line of business.
- Non-operating expenses can include regular interest payments due on the debt, or one-time expenses such a restructuring charge.
Secondly, expenses are either cash expenses or noncash expenses
- Inventory purchase expense, for example, is a cash expense.
- The most familiar example of a noncash expense, for instance, is depreciation expense. Other noncash expenses include bad-debt expense and inventory write-down.
Every expenditure in business is a financial event. And, expenditures—like all other financial events—must register in one way or another in the firm's accounting system.
Most business firms practice double-entry accrual accounting, even though this approach is more complex and more difficult to use than the simpler alternative, single entry accounting. Public companies and other firms use double-entry accounting because they cannot otherwise meet government and regulatory requirements for reporting and record-keeping. With a single entry system alone, moreover, firms cannot accurately track their assets, liabilities, equities, revenues, and expenses. double-entry accrual accounting meets these needs.
As a result, every expenditure and every other financial event:
- Impacts at least two accounting system accounts.
- Calls for at least one debit transaction and one credit transaction. Total debits for the event must equal (offset) total credits for the event.
When entering an expenditure transaction into the system, bookkeepers and accountants are responsible for knowing (a) which accounts to impact, and (b) which accounts to credit and which to debit.
When a firm acquires an asset with cash, the financial event is an expenditure but not an expense. The reason that asset acquisitions do not initially register as expenses has to do with several core principles of accrual accounting:
- Firms report (claim) expenses only when incurring them.
- Firms incur expenses for assets only as they use up, wear out, or exhaust them.
- For depreciating assets, the period over which firms incur expenses by using up assets is the asset's depreciation life. A similar value decrease occurs over time for amortizing assets through an amortization life.
- Firms use up the value of inventory assets across the period they use to convert the inventory into cash or Accounts Receivable.
- Other kinds of assets, such as prepaid expenses, wasting assets, or intangible assets also have "lives" specified by accounting rules, over which they lose book value as they incur expenses.
In brief, an expense by definition decreases the value of the asset base by paying funds out of the firm. By contrast, a cash expenditure for asset purchase transfers one pool of asset value (cash) into another asset category (such as Merchandise Inventory, or Factory Machines).
The asset expenditure brings expenses over time, however, as the firm incurs charged for depreciation, amortization, or usage. These asset-caused expenses do reduce the asset base and do educe earnings (profits).
Profit = Revenues – Expenses
Expense item expenditures can appear under any of the five major Income statement headings.
- Expense Item for Cost of goods sold COGS.
Cost of goods sold (COGS, CGS, or cost of services, or cost of sales) is the total cost of acquiring raw materials and turning them into finished goods or service deliveries.
- Operating Expenses for Selling.
Selling expenses include salaries and commissions for salespeople.
- Operating Expenses - General & Administrative (G&A).
Operating expenses pay for operating the firm's normal line of business. G&A expenses therefore include such things as executive salaries, administrative employee wages, research and development, travel, training, and IT support, and depreciation.
- Financial Expenses.
Financial expenses include payments resulting from borrowing or earning income from financial investments (Note that this category exists primarily for firms that are not in financial industries).
- Extraordinary Items or Non-Recurring Items
These are costs for large one-time events or transactions, outside the firm's normal line of business.
Charging expenses in any of these categories—including both cash and noncash expenses—lower "bottom-line" profits.
Firms sometimes disburse funds directly to company owners (shareholders). These payments are expenditures, not expenses.
For instance, when a public company closes its books after a profitable accounting period, its Board of Directors designates how the firm distributes this income. The Board formally announces this distribution through the Statement of Retained Earnings. This report shows how Income Statement profits from the period either transfer to the Balance sheet, as retained earnings or through expenditures to shareholders as dividends.
Dividend payments are not expenses as long as the firm pays them from "Surplus Undivided Funds accounts," or "Drawing Accounts." Funds in these accounts are from the period's profits which have not yet entered the equity base, which the firm does not carry as assets. By contrast, any payments from existing Retained earnings would draw down the equity base and therefore qualify as expenses.
Owner disbursements, in other words, do not contribute to the bottom line profit calculation.
In many cases, firms repay debt with a combination of expenditures and expenses.
Taking on debt brings an obligation to repay, of course, but taking on debt also incurs expenses. The largest and most familiar expenses from debt are interest obligations, which debtors normally pay periodically to a lender or bondholders.
The only important exceptions to the periodic interest payment practice are zero-coupon bonds, such as US Government Savings Bonds. For these bonds, the issuer completely pays both interest and principle with a single lump-sum payment at maturity. The name sinking fund refers to "retiring the debt" or, more colorfully, "sinking the debt."
In any case, repayment of the loan principle itself represents an expenditure. Payments for interest and other borrowing costs (such as loan-origination fees) are expense payments. As a result, when a firm makes a periodic bank loan payment, accountants recognize two components in the payment total: (1) An expenditure that contributes towards paying off the loan principal, and (2) an expense component covering interest due.
Firms often anticipate the loan repayment expenditure using a kind of special purpose savings account, a sinking fund. Sinking funds normally reside in interest-paying bank accounts, which means payments into the account earn interest on themselves thereby helping to build the fund.
Sinking funds are cash assets, but on the Balance sheet they list under "Long-Term Assets" and not "Current Assets." They belong under Long-term assets because their funds are not available for any other purpose until they ultimately pay off the debt, When it is time to pay off the debt, the sinking fund balance transfers to a normal (Current Assets) cash account, and from their transfers as an expenditure to retire the debt.