Understanding Accounts Expenses: A Comprehensive Guide

An expense in accounting is the money spent, or costs incurred, by a business in their effort to generate revenues. Essentially, accounts expenses represent the cost of doing business; they are the sum of all the activities that hopefully generate a profit.

It is important to understand the difference between “cost” and “expense” since they each have a distinct meaning in accounting. Cost is the monetary measure (cash) that has been given up in order to buy an asset. An expense is a cost that has expired or been taken up by activities that help generate revenueRevenueRevenue is the value of all sales of goods and services recognized by a company in a period. Revenue (also referred to as Sales or Income). Therefore, all expenses are costs, but not all costs are expenses.

What is an Expense?

An expense is defined in the following ways:

• Office supplies use up the cash (asset)
• Depreciation expense, which is a charge to reduce the book value of capital equipmentPP&E (Property, Plant and Equipment)PP&E (Property, Plant, and Equipment) is one of the core non-current assets found on the balance sheet. PP&E is impacted by Capex, (e.g., a machine or a building) to reflect its usage over a period.
• A prepaid expense, such as prepaid rent, is an asset that turns into a cash expense as the rent is used up each month

A summary of all expenses is included in the income statementIncome StatementThe Income Statement is one of a company's core financial statements that shows their profit and loss over a period of time. The profit or as deductions from the total revenue. Revenue minus expenses equals the total net profit of a company for a given period.

In the double-entry bookkeeping system, expenses are one of the five main groups where financial transactions are categorized. Other categories include the owner’s equityOwner’s EquityOwner's Equity is defined as the proportion of the total value of a company’s assets that can be claimed by the owners (sole proprietorship or partnership) and by the shareholders (if it is a corporation). It is calculated by deducting all liabilities from the total value of an asset (Equity = Assets – Liabilities)., assets, liabilities, and revenue. Expenses in double-entry bookkeeping are recorded as a debit to a specific expense account. A corresponding credit entry is made that will reduce an asset or increase a liability.

The purchase of an asset such as land or equipment is not considered a simple expense but rather a capital expenditure. Assets are expensed throughout their useful life through depreciation and amortizationAmortizationAmortization refers to the process of paying off a debt through scheduled, pre-determined installments that include principal and interest.

Expenses in Cash Accounting and Accrual Accounting

Expenses are recorded in the books on the basis of the accounting system chosen by the business, either through an accrual basis or a cash basis. Under the accrual methodAccrual PrincipleThe accrual principle is an accounting concept that requires transactions to be recorded in the time period in which they occur, regardless of, the expense for the good or service is recorded when the legal obligation is complete; that is when the goods have been received or the service has been performed.

Under cash accounting, the expense is only recorded when the actual cash has been paid. For example, a utility expense incurred in April but paid in May will be recorded as an expense in April under the accrual method but recorded as an expense in May under the cash method – as this is when the cash is actually paid.

Accrual accounting is based on the matching principle that ensures that accurate profits are reflected for every accounting period. The revenue for each period is matched to the expenses incurred in earning that revenue during the same accounting period. For example, sale commission expenses will be recorded in the period that the related sales are reported, regardless of when the commission was actually paid.

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:

1. Cost of Goods Sold (COGS)

Cost of Goods Sold (COGS)Cost of Goods Sold (COGS)Cost of Goods Sold (COGS) measures the “direct cost” incurred in the production of any goods or services. It includes material cost, direct 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.

2. 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.

3. 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.

4. 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.

5. Non-Operating Expenses

These are costs that cannot be linked back to operating revenues. Interest expenseInterest ExpenseInterest expense arises out of a company that finances through debt or capital leases. Interest is found in the income statement, but can also 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.

Non-Cash 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 depreciationAccumulated DepreciationAccumulated depreciation is the total amount of depreciation expense allocated to a specific asset since the asset was put into use.
• 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.

More Resources

Thank you for reading CFI’s guide to Accounts Expenses. CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)®Become a Certified Financial Modeling & Valuation Analyst (FMVA)®CFI's Financial Modeling and Valuation Analyst (FMVA)® certification will help you gain the confidence you need in your finance career. Enroll today! certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below:

• Capital ExpendituresCapital ExpendituresCapital expenditures refer to funds that are used by a company for the purchase, improvement, or maintenance of long-term assets to improve
• Cash Flow StatementCash Flow Statement​A cash flow Statement contains information on how much cash a company generated and used during a given period.
• Capitalizing R&D ExpensesCapitalizing R&D ExpensesGuide to R&D capitalization vs R&D expense. Under the GAAP, firms are required to expense research and development (R&D) in the year they are
• GoodwillGoodwillIn accounting, goodwill is an intangible asset. The concept of goodwill comes into play when a company looking to acquire another company is