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Expense, Expense Category Accounts
Definition, Meaning Explained, Accounting and Budgeting Examples

 

Accountants define expense as a decrease in owners equity caused by using up assets. This definition includes cash and non-cash expenses.

Expenses are center stage in daily operations, budgeting, planning, and financial reporting.

What is the Meaning of Expense?

Spending on employee wages, for instance, is an expense because it uses up cash assets. The broader definition also covers non-cash expenses, such as depreciation or bad debt expenses. However, every expense event—cash or non-cash—calls for an impact on an expense category account.

This article further defines and explains expense and expense-related terms. Note that "expense" appear in two contexts:

  • Firstly, the term refers to a concept in financial accounting. In this context, expenses are especially prominent on the Income statement.
  • Secondly, the term refers to a concept in budgeting. Budgets exist primarily to plan, track, and control expense spending.

Explaining Expense in Context

Sections below further define, describe and illustrate expense. Note that the term appears in context with related terms and concepts from the fields of budgeting, cost accounting, and financial accounting, including the following:

Expense
Expenditure
Cost
Operating Expense OPEX
Cash Expense
Non-Cash Expense
Expense Category Account
Depreciation Expense
Bad Debt Expense
Income Statement
Cost of Goods Sold
Operating Expenses
Financial Expense
Extraordinary Expense
Capital Expenditure CAPEX
 

Contents

Related Topics

 

Define Your Terms!
Exactly What Do Expenditure, Expense, and Cost Mean?

Many people confuse expense-related terms or use them imprecisely. Many, for instance, see the terms costly and expensive as synonyms. And, many people in business make little distinction between the terms expense, expenditure, and cost.

These terms all have different meanings, however. Those engaged in budgeting or financial accounting need to understand precisely the meaning of each.

Defining Cost

Exhibit 1 below shows that the broadest or most inclusive of these terms is cost.All of the items in light blue and yellow cells are, arguably, costs.

  • In accounting, the term cost primarily means an amount of money given up to acquire something. The name of an activity, "cost accounting," is an example of this usage.
  • However, businesspeople also use the term cost widely—and appropriately—when referring to other kinds of losses or negative impacts. Management may say, for example, that a recently declared pay freeze has "cost the company dearly in lower employee morale." Or, marketers may state that the company is paying a substantial cost, or heavy price, in a damaged brand image due to poor product quality.

Exhibit 1 below recognizes both the broader meaning of cost and the accountant's narrower definition.

 

Exhibit 1. Businesspeople often confuse the terms cost, expenditure, and expense. However, these, terms have different meanings and are not interchangeable.

Defining Expenditure

An "Expenditure" is a spending activity the firm pays, serving at least four different purposes:

  • Firstly, to acquire an asset, either through the purchase of a capital asset, or acquisition of a deferred expense.
  • Secondly, to distribute funds to owners (e.g., as dividends or other direct distribution through drawing accounts.).
  • Thirdly, to reduce or pay off a liability (debt). Examples including paying off a bank loan or retiring a bond issue.
  • Fourthly, spending for an expense. An expense is a reduction in owner's equity due to reducing assets.

Defining Expense

Expense:A decrease in owner’s equity due to using up assets.

Kinds of Expenses

Firstly, "expenses" are either operating expenses OPEX or non-operating expenses. Secondly, "expenses" are either cash expenses or non-cash expenses. Sections below further explain the role of these distinctions for budgeting and financial reporting.

Where Are Expenses on the Income Statement?
Expense Items Appear In All Major Income Statement Categories

The Income statement equation shows how profits result from the period's incoming and outgoing funds:

Profit = Revenues – Expenses

What Are the Important Income Statement Expense Headings?

Expense items can appear under any of the five major Income statement headings.

1. Expenses for Cost of goods sold (COGS)

Cost of Goods Sold (COGS or CGS) is the total cost of acquiring raw materials and turning them into finished products. COGS usually does not include expenses which apply to the whole enterprise, or to selling, or administrative costs. For firms outside the financial industries, COGS also excludes interest expenses and losses due to extraordinary items.

  • COGS for manufacturing firms usually has three parts: direct labor, direct materials, and manufacturing overhead.
  • Firms that sell services report the costs of service delivery as Cost of Services instead of COGS.
  • Firms selling both services and goods may instead report their direct costs for services and products as Cost of Sales.

Example COGS expenses include the following:

2. Operating Expenses - Selling

These are expenses for selling. Selling expenses may, therefore, include such things as:

3. Operating Expenses - General & Administrative (G&A)

These are essential expenses for running the firm's core line of business. G&A expenses may, therefore, include such things as:

Categories "2" and "3" above sometimes appear as a single heading Selling, General and administrative expenses (SG&A). And, these expenses appear on some Income statements all under a single heading "Operating expenses."

4. Financial Expenses

These are costs associated with borrowing or earning income from financial investments. Note that this category exists only for firms that are not in financial services. For these firms, therefore, financial expenses are incurred outside the firm's usual line of business.

For firms not in financial industries, these expenses may include the following:

  • Loan origination fees.
  • Interest on borrowed funds.

5. Extraordinary Expenses

These are the costs for large one-time events or transactions, outside the firm's core line of business. These may include the costs of:

Expenses Impact Income Statement Profits
Expenses Impact Gross, Operating, and BottomLine Net Profits

It is essential to know which Income statement category a given expense item belongs in for at least two reasons:

  • Firstly, the class heading determines which budget includes this item.
  • Secondly, the category determines whether the expense item impacts Gross profit, Operating profit, or only Net Profit.

Cost of Goods Sold Impacts Profits

Gross profit is the difference between total COGS and Net sales revenues. Gross profit, of course, is an amount, expressed in currency units. Business people often find it helpful to deal instead with Gross margin, which is Gross profit as a percentage of Net Sales.

The high-level Income statement shows the Gross profit for the entire reporting firm. The firm's leaders, however, have a keen interest in "drilling down" from the high-level figures. They may need especially to uncover actual Gross profits for individual products, services, and product lines. These figures may show, for instance, that some products are very profitable while others are not. This information is crucial for effective product management and product strategy decisions.

To find product "Gross profits," the firm can estimate sales revenues, direct materials costs, and direct labor costs rather easily and rather directly. However, it is not always so easy to estimate "indirect" or "overhead" expenses. These costs are especially difficult to estimate when overhead or indirect activities support multiple products or product lines.

Besides impacting Gross profit, COGS also affects Income statement "Profit" results that appear below Gross profit. Consequently, Operating profit and Net profit reflect the impact of "Cost of goods sold" (or "Cost of Services," or "Cost of Sales").

Operating Expenses Impact Profits

The Income statement category Operating Expenses typically appears with two main sub-categories:

  • Firstly, Selling Expenses          Secondly, General and Administrative Expenses

Note that some statements replace the heading "Operating Expenses" with Selling, General, and Administrative Expenses, or SG&A.

These expenses do not impact Income statement Gross profit because they appear below (after) the Gross profit line. For this reason, these expenses are sometimes called "below the line" costs. Operating expenses, however, do impact Operating profit and bottom line Net profit.

Financial and Extraordinary Item Expenses Impact Profits

Extraordinary expenses and Financial expenses usually appear below Operating profit on the Income statement. Only when the firm operates in the financial industry, do financial expenses appear higher on the Income statement. For financial firms, these expenses may rightfully belong under "Cost of Services" or "Operating Expenses. Outside the financial industries, of course, these expenses impact only one profit result, bottom line Net profit.

What Are Non-Cash Expenses?

Non-cash expenses are charges against earnings which exist solely to reduce Net profit (thereby lowering taxes). They do not represent actual cash flow. Note that "non-cash expenses" are not an Income statement category. They are instead a kind of expense that can appear in any of the major categories above.

An "expense" is a decrease in owner’s equity caused by using up assets.

Income statement depreciation is therefore rightfully called "expense," even though it does not result in cash flow. Depreciation charges, however, bring several other non-cash actions:

  • Firstly, a debit to a Depreciation expense account increases that account balance.
  • Secondly, a credit to a contra Asset account, Accumulated depreciation, increases that account balance.
  • Thirdly, on the Income statement, the book value of the asset base decreases by an amount equal to the Accumulated depreciation balance.

Example Income Statement
Income Profit = Revenues – Expenses

Expenses are center stage in daily operations, budgeting, planning, and preparing the Income statement report. Exhibit 2 is an example Income statement with significant expense categories including (1) Cost of goods sold, (2) Selling expenses, and (3) Administrative (overhead) expense.

Grande Corporation                                   Figures in $1,000's
Income Statement for Year Ended 31 December 20YY   
Revenues
Gross sales revenues
   "Less" returns & allowances
      Net sales revenues
Cost of goods sold
   Direct materials
   Direct labor
   Manufacturing Overhead
      Indirect labor
      Depreciation, mfr equipment
      Other mfr overhead
      Net mfr overhead
         The net cost of goods sold
Gross Profit








5,263
360
  4,000


33,329
    346


6,320
  6,100




 9,623



32,983








 22,043
 10,940
Operating Expenses
Selling expenses

   Sales salaries
   Warranty expenses
   Depreciation, Store equip
   Other selling expenses
          Total selling expenses
General & Admin expenses
   Administrative salaries
   Rent expenses
   Depreciation, computers
   Other general & admin expenses
      Total general & admin exp
           Total operating expenses
Operating Income Before Taxes
  

  4,200
  730
  120
   972


1,229
180
179
   200






6,022





  1,788













  7,810
  3,130
  Financial revenue & Expenses
  Revenue from investments
      Less interest expense
      Net financial gain (expense)
  Income before tax & ext items
  Less income tax on operations
    Income before extraordinary items
 



118
  511



  (393)
 2,737
  958
1,779
Extraordinary Items
   Sale of land
   Less initial cost
      Net gain on sale of land
      Less income tax on the gain
         Extraord items after tax
 
610
  145



465
  118





  347
Net Income (Profit)       2,126
 

Exhibit 2. Detailed example Income statement, showing how Revenue and Expense account items represent the Income statement equation:
    Income = Revenues – Expenses.

What Are Expense Category Accounts?
What Other Account Categories Appear in the Chart of Accounts?

Chart of Accounts: "Balance Sheet" Accounts and "Income Statement" Accounts

A. Balance Sheet Accounts:

1. Asset Accounts: Items of Value Owned for Operating the Business. For example:

  •      Cash on hand
  •      Accounts receivable

2. Liability Accounts: Debts Owed by the Business. For instance

  •      Accounts payable
  •     Salaries payable

3. Equity Accounts: The Owner's Claim to Business Assets. For example:

  •     Owner capital
  •   Retained earnings

B. Income Statement Accounts".

4. Revenue Accounts: Funds Earned From the Sale of Goods and Services. For instance:

  •     Product sales revenues
  •      Interest earned revenues

5. Expense Accounts: Costs Incurred in the Course of Business. For example:

  •     Direct labor costs
  •     Advertising costs

Expense Account Transactions

Every debit to an expense account occurs along with an equal, offsetting credit transaction in another account. With expense transactions, the offsetting credit usually impacts an account in another category, for example, an asset account, or a liability account.

Consider for instance what happens when a firm buys office supplies (an expense) with cash (an asset):

  • For the purchase, the firm records a debit to an expense account (Increasing the expense account's balance).
  • At the same time, the firm enters a creditto an asset account, "Cash on hand." The credit transaction decreases the asset account balance.

How Are Expense Items Budgeted?
What Are the Main Budget Categories?

Operating Expenses and Operating Budgets

Tax savings = Expense * Tax rate

Consider, for instance, tax liabilities for a firm that pays tax on operating income and takes in revenues of $1,000.

  • If the tax rate is 32%, and if there are no expenses, the tax liability for $1,000 is $320.
  • If instead, however, expenses during the same period are $600, the tax liability reduces to $128. That is because the 32% tax applies only to $1,000 less $600, that is, $400, yielding a tax liability of $128.

In conclusion, the firm enjoys tax savings is$192, compared to the same revenues with no expenses:

Tax Savings
     = $600 * 32%
     = $192

Capital Expenditures and Capital Budgets CAPEX 

CAPEX vs. OPEX Differences

Classifying spending as either CAPEX or OPEX depends on:

  • What the firm buys
  • The use of the purchase
  • The country's tax laws

As a result, tax-paying companies usually define specific criteria, or "rules," that qualify an acquisition as CAPEX. Expenses that do not meet these criteria are, by default, OPEX.

Capitalization Criteria

Capitalization criteria, in fact, serve three purposes:

  • Firstly, these rules help ensure that the firm complies with local tax laws.
  • Secondly, criteria help ensure consistencyin the way that acquisitions qualify as CAPEX.
  • Thirdly, public criteria assure third-party auditors that the firm's financial statements conform to GAAP.

Typical requirements for capitalization might include, for instance:

  • A minimum useful life (for example, one year or more).
  • A minimum purchase price (for example, $1,000).
  • The acquisition must support the firm's usual line of business.

Capitalization, incidentally, can include more than direct item purchases. Note that projects that build capital assets are called capital projects. And, capital projects may incur some expenses that would not otherwise qualify as CAPEX, but which do qualify when they are part of a capital project. As a result, capital projects require CAPEX funding.

IT Systems integration services, for instance, do not by themselves qualify as CAPEX. However, when they are part of a project that results in a capitalized IT system, these service expenses can be CAPEX.

CAPEX vs. OPEX Differences

Note that expenditures for capital assets (CAPEX) contrast with spending that covers operating expenses (OPEX) or investments unrelated to the company's core business.