What Are Expenses?
Expenses are the costs an entity incurs to generate revenue.
More technically, an expense is any transaction arising during an entity’s core operations that reduces the owners’ interest. It is any reduction in an asset or increase in a liability that decreases equity besides those relating to equity distribution to shareholders.
Expenses are deducted from an entity’s revenue to calculate its profit. When a company has more expenses than revenue, the entity has made a loss – they’ve spent more than they earned.
Cash Basis vs. Accruals Basis – How To Account For Expenses?
Entities have two main concepts when accounting for expenses:
- Cash Basis Concept
- Accrual Basis Concept
Under the cash basis concept, expenses are recorded when cash is paid – not when the good or service has been received. If an entity uses electricity for three months and pays the bill in the third month, the entirety of the bill would be recorded and expensed in that third month. If the electricity bill is £600 for the three months ending 31 December, £600 would be booked and expensed in December.
On the contrary, the accruals concept requires that an entity record expenses when the benefit is received/consumed – not when cash is paid. If an entity uses electricity for three months and pays the bill in the third month, the electricity would be recorded and expensed equally across the three months.
If the electricity bill is £600 for the three months ending 31 December, £200 will be expensed at the end of each of the three months. The accruals concept matches expenses to when the entity benefitted from the good or service – not when cash is paid.
Most entities use the accruals basis concept when accounting for expenses.
Types of Expenses
Expenses are mainly split into the following categories:
- Operating Expenses
- Non-Operating Expenses
But depending on when payments are made, they can be classed as:
- Accrued Expenses
- Prepaid Expenses
What Are Operating Expenses?
Often abbreviated as OpEx, operating expenses are the expenses an entity incurs during its core operations. They are the expenses an entity incurs to ensure it continues operating. Some examples of operating expenses are the cost of sales and selling general and administrative (SG&A) expenses.
Operating Expenses Examples
| Cost of Sales | SG&A Expenses |
| Purchases of inventory | Marketing expense |
| Transportation/Carriage in | Utility bills |
| Purchases of raw materials | Payroll |
What Are Non-Operating Expenses?
Non-operating expenses don’t relate to an entity’s core operations. Since they don’t arise from an entity’s day-to-day activities, they are separated from operating expenses and displayed on a separate line in the entity’s Statement of Profit or Loss. Some examples of non-operating expenses include interest expenses and legal fees.
What Are Accrued Expenses?
Also called expenses owing, accrued expenses occur when an entity consumes a benefit (good or service) but hasn’t received an invoice to pay the supplier. They usually arise when an entity consumes a good or service whose cost depends on how much the company uses – like electricity or water.
Since the entity owes cash to the supplier, accrued expenses are held as current liabilities on the Statement of Financial Position. They are also added to the respective account balances when preparing the entity’s Statement of Profit or Loss.
For example. If a company’s electricity expense for the first ten months of the year is £5,000, £5,000 will be charged to its Statement of Profit or Loss. The company then used electricity amounting to £1,000 in the final two months but received the invoice after its financial year-end. Because the accruals concept requires that expenses are recorded when consumed and not when cash is paid, the entity’s electricity bill for that year would be £6,000.
The £1,000 accrual is added to the electricity account balance to be expensed for the year and then transferred to current liabilities in the Statement of Financial Position, representing an obligation to pay their electricity supplier.
What Are Prepaid Expenses?
Prepaid expenses relate to an amount paid before receiving a benefit and usually occur when an entity pays for services like insurance. Since cash is paid and the service hasn’t been received, prepaid expenses are held as current assets on an entity’s Statement of Financial Position – the entity is owed a service from the supplier.
Prepaid expenses are recorded as prepayments (current assets) before they are expensed. They are recognised and transferred to the expense account when the entity consumes/receives the benefit.
For example. If a company buys insurance for £6,000 in July, which covers twelve months, it would have prepaid expenses of £6,000 on its Statement of Financial Position. When the entity receives the benefit, the accountants would recognise the insurance expense at each month’s end by reducing the prepayment account (asset) and increasing the insurance expense account by £500.
At the financial year-end, the entity would have an insurance expense of £3,000 to charge to its Statement of Profit or Loss and a £3,000 insurance prepayment under current assets on its Statement of Financial Position.
References
Liberto, D. (2003)Expense: Definition, types, and how expenses are recorded,Investopedia. Available at: https://www.investopedia.com/terms/e/expense.asp (Accessed: September 7, 2023).
Weetman, P. (2019) “Financial accounting terms defined,” inFinancial accounting: An introduction. 8th ed. London, England: Pearson Education, pp. G1–G10.
