Cost incurred by an entity to generate revenues is known as expense. To make money, you have to spend as well. The costs of running the business and generating revenues in a particular period are termed as expenses and reported in the income statement for that particular period.
Moneys spent by an entity for its business is termed as expenditure. The expenditure is classified as either capital expenditure or revenue expenditure depending on when the entity expects to receive the benefits associated with that expenditure. Benefits of capital expenditure are enjoyed by the business in the long term. Therefore, capital expenditure is capitalized and systematically charged as expense in the income statement to match with the expected economic benefits generated by that expenditure (in accordance with the matching principle). Whereas revenue expenditure is by definition an expenditure which is expected to generate economic benefits associated with that expenditure in the same period, therefore revenue expenditure is recorded as expense in the period in which it is incurred.
What are expenses examples?
Here are some examples of common expenses:
- Manufacturing costs of goods sold.
- Salaries and wages of employees.
- Rent and insurance expense.
- Depreciation expense which is the systematic allocation of capital expenditure to the income statement.
- Repair and maintenance.
- Utility expenses (electricity, gas, water etc.)
- Taxes and business rates.
- Advertising expenses
- Finance cost
In the income statement, expenses are categorized into three or four major classifications (for e.g., cost of sales, admin expenses, selling expenses etc.) and totals of all expenses of a particular period are reported in the income statement. These expenses are deducted from the revenues of that period to present the profit or loss for the period of the entity.
Systems of recording expenses
There are two systems of accounting, namely cash basis of accounting and accrual basis of accounting. In cash based accounting, expense can be defined as the money spent by a business. Regardless of the period to which it belongs, an expense will only be recorded when the cash is paid. This approach is considered old fashioned and may only be suitable for very small businesses. Accrual based accounting is the approach that is followed all over the world as it is based on matching principle and results in accurate reporting profits.
What is an expense? – Accrual based accounting
In accrual based accounting, expenses mean expenses incurred by the business during a particular period of time regardless of when they are paid. It is important to understand the word “incurred”. It is often understood that an entity’s expenses are the amounts that are paid by the entity. This is true if you are following “cash basis of accounting”. However, “accrual basis of accounting” is the modern approach and under this approach, expenses are defined as the expenses incurred by the business.
Let’s look at how the accountant of Ricardo Garments Inc. prepares the income statement of the business for the year ended 31 December 20XX. Electricity, telephone and other utilities are used in the month of December 20XX, but these are billed in January of next year and are paid in next year as well. But he is taking the utility expense of December 20XX as well while preparing the income statement. Is he right or wrong? He is right! as the utilities have been used by the business in December and their expense is actually incurred in December, even though it is paid in January next year. Similarly, December salaries of all the staff of Ricardo Garments Inc. are paid in January, but these are also included in expenses for the year as the staff has worked in December and the salary expense is incurred by the business regardless of timing of payment.