When it comes to running a company or a business, there are a lot of factors that come into play. One of the important ones is the buying and selling of assets that will help the business in its operations and will profit the company or business in one way or another. The cost of the assets which are bought by the company for the above purpose is expressed in the form of the company’s expenditure or expenses. In other words you can say that an expense is the cost of an asset which has been used by the company in its operations with a goal to raise revenues. So, an expense is simply the use of an asset to increase the sales and thereby increase the profit of the company. Although in normal language, expenditure and expenses may be thought of as the cash that is paid out, it is not how it works. Expenses are created only when the asset is used up and not when the cash is paid out. Understanding the concept of costs and expenses is highly important when running a business. That is why to understand how expenses work in a business, let us have a brief yet informative look at the term and see the different types of expenses that occur in businesses.
What is an Expense?
The term expense refers to the cost of operations that a company or business incurs to generate revenues. If you want your business to succeed, it will certainly come at some cost, as you will need different types of assets to help you in your company’s operations that will help increase the company’s sales. The costs that go in for getting and using such assets can be referred to as expenses.
The common expenses that a business has to handle include the payments to suppliers, employee wages, factory leases, and equipment depreciation. The expenses that are tax-deductible can be added by the businesses or companies on their income tax returns to lower their taxable income and tax liability. However, not all expenses are deductible and it is important to know that businesses cannot claim their personal, non-business expenses as business deductions. This includes lobbying expenses, penalties and fines.
Accountants of the company can record expenses through one of the two accounting methods including cash basis or accrual basis. Operating expenses and non-operating expenses are the two main and important types of business expenses.
When managing a company, one of the main goals of any management is to make maximum profits. The profits of any business or company can be increased by achieving higher revenues while ensuring that the expenses are kept in check. Slashing costs and cutting expenses can be helpful for the companies as far as making maximum money from sales is concerned. However, cutting too many expenses can also have a negative effect on the business. Let us understand this through a simple example; for example if you have paid an advertising company for your company’s advertisement, however, due to some reason you want to save on that money and therefore decide to cut the expenses spent on the advertisement. Although this might save you and your company some expenses, it will also reduce the visibility of the company and can cost you potential customers and clients.
Every company or business has an expense account which is a contra equity account. This account has a debit balance. In simple terms, this means that the equities of the business or company are decreased with the more number of expenses generated by the company. Companies usually break down their revenues and expenses in their income statements which are made by the accounting department.
Accountants record these expenses through one of the two accounting methods including cash basis and accrual basis. When recording the expenses through the cash basis method, the expenses are recorded only when they are paid. However, when recording the expenses through the accrual method, expenses are recorded when they are incurred. Both these methods can be better understood with relevant examples.
For example, an owner of a company calls a mechanic to repair a couple of elevators in the company. If a cash basis method is used for recording the expenses, then the expense of the above repair will be recorded when the invoice is paid. However, a company that records the expenses using accrual basis method, the record of the expenses will be made when the company receives the service.
Most companies prefer the accrual basis method for recording expenses and it is ensured that they match up with the revenues that are reported in the accounting periods. Expenses are used to calculate a company’s net income, which is calculated by the following formula:
Net income of a company = the company’s revenues − the company’s expenses
While talking about expenses in business, it is also important to understand the capital expenses or capital expenditures which are the funds that are used by a company or a business to acquire, upgrade and maintain physical assets such as property, business, industrial plants, technology or equipment.
Types of Expenses
Now that we have gone through the basics of the term “expenses” in business and have understood its importance, let us have a look at the types of expenses that are present. There are two main types or categories of business expenses— operating expenses and non-operating expenses. To understand both the categories better, let’s go through them one by one.
Operating Expenses Operating expenses are the expenses which are related to the company’s main activities. These include the cost of goods sold, administrative fees, and rent. Other costs that come under the operating expenses of the company or business are marketing costs, advertising costs, salaries of employees, promotion costs, insurance and employee benefits.
Non-operating Expenses Non-operating expenses are the expenses which are not directly related to the business’ core operations. These include interest charges and other costs that are associated with borrowing money.
How Does Expense Work?
Profit maximisation is the primary objective of the management of any business organisation. It can be achieved by increasing revenues and keeping expenses in check at the same time. Cutting costs helps entities earn even more money from sales. Still, it can have serious repercussions if expenses are heavily cut.
For instance, expending less on advertising and promotion will reduce costs. However, it will eventually lower the company’s brand visibility and its ability to approach potential customers.
Accounting of Expenses
Business entities give a break up of their revenues and expenses in their statement of profit and loss. They use either cash or accrual basis to record expenses. Under the cash accounting method, the expenses are recorded when actually paid. On the other hand, under the accrual method, expenses are accounted for when the liability arises.
For instance, if a business entity spends on coffee and tea for its employees in the office, it uses cash basis to record the expense when it pays the invoice. Under the accrual method, the accountant would record the staff welfare expense when the business entity receives the service.
Expenses are usually recorded on an accrual basis, securing a match with the revenues recorded in accounting periods. Accordingly, expenses are used to compute the net income. The equation to estimate net income is total revenue minus total expense.
Under the Income Tax Act, businesses are not allowed to claim their personal or non-business expenses as business deductions. They also cannot claim penalties and fines.
Capital expenditure refers to funds utilised by a company to acquire, improve, and maintain fixed physical assets such as property, buildings, an industrial plant, technology, or equipment.
