Spending on employee wages, for instance, is an expense because it uses up cash assets. However, the definition above also covers noncash expenses, such as depreciation or bad debt expenses. Every expense—cash or noncash—calls for an impact on an Expense Account in the accounting system. And, every expense of either kind lowers the income statement "bottom line" in the same way
Explaining Expense in Context
This article further defines and explains expense in context with terms such as expenditure and cost. Note that "expense" appear in two contexts:
- First, 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.
Sections below emphasize these themes:
- The precise meaning of "Expense" in accounting.
- Contrasting the accountant's version of Expense with the term's broader use in business, alongside terms such as Cost and Expenditure.
- Examples showing the role of Expenses in financial reporting, Especially on the Income Statement.
Many people confuse expense-related terms or use them imprecisely. Many, for instance, see the terms costly and expensive as synonyms. And, people sometimes make no 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.
Exhibit 1 below shows that cost is the most inclusive of these terms. 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 say that the company is paying a substantial cost for damage to brand image brand image.
Exhibit 1 below recognizes both the broader meaning of cost and the accountant's narrower definition.
An "Expenditure" is a spending activity the firm pays, serving at least four different purposes:
- First, to acquire an asset, either by purchasing a capital asset or by acquiring a deferred expense.
- Second, to distribute funds to owners (e.g., as shareholder dividends or direct distribution through drawing accounts.).
- Third, to reduce or pay off a liability (debt). Examples including paying off a bank loan or retiring a bond issue.
- Fourth, spending for an expense. An expense is a reduction in owner's equity due to using up assets.
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 noncash expenses. Sections below further explain the role of these distinctions for budgeting and financial reporting.
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 and 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 include such things as:
Categories "2" and "3" above sometimes appear as a single heading Selling, General and administrative expenses (SG&A). However, these expenses may also appear on the Income statement 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:
It is essential to know which Income statement category a given expense item belongs in for at least two reasons:
- First, the class heading determines which budget includes this item.
- Second, 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 prefer instead to focus on 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. Management and officers, 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 profitable and which products 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 directly. However, it is not always so easy to estimate indirect or overhead expenses directly. 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 other income statement "Profits" that appear below Gross profit. Consequently, Operating profit and bottom line Net profit alsomreflect 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.
Operating expenses do not impact Income statement Gross profit because they appear below (after) the Gross profit line. Accordingly, accountants refer to these expenses as "below the line" expenses. 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 Noncash Expenses?
Noncash expenses are charges against earnings which exist solely to reduce Net profit (thereby lowering income taxes). They do not represent actual cash flow. Note that "noncash 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 noncash actions:
- Firs, a debit to a Depreciation expense account increases that account balance.
- Second, a credit to a contra Asset account, Accumulated depreciation, increases that account balance.
- Third, on the Income statement, the book value of the asset base decreases by an amount equal to the Accumulated depreciation balance.
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.
"Balance Sheet" Accounts and "Income Statement" Accounts
Three Types of Balance Sheet Accounts
- Asset Accounts such as "Cash on Hand," "Accounts Receivable"
- Liability Accounts such as "Accounts Payable," "Salaries Payable"
- Equity Accounts such as "Owner Capital," "Retained Earnings",
Two Types of Income Statement Accounts
- Revenue Accounts such as "Product Sales Revenues," "Service Revenues"
- Expense Accounts such as "Direct Labor Expense," "Advertising Expense"
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 credit to an asset account, "Cash on hand." The credit transaction decreases the asset account balance.
Operating Expenses and Operating Budgets
Tax savings = Expense * Tax rate
Consider, for instance, tax liabilities for a firm that pays a 32% 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:
= $600 * 32%
Capital Expenditures and Capital Budgets CAPEX
CAPEX vs. OPEX Differences
Classifying spending as either CAPEX or OPEX depends on several factors:
- What the firm buys.
- The use of the purchase.
- The country's tax laws.
To avoid confusion, 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, serve several purposes:
- First, these rules help ensure that the firm complies with local tax laws.
- Second, criteria help ensure consistency in the way that acquisitions qualify as CAPEX.
- Third, 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 capital projects. 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 outside the company's core business.