What Is an Expense?
An expense is the cost businesses incur in their operations to generate revenue. Familiarly, this could be described as ‘paying the price to earn income.’ Examples include payments to suppliers, employee wages, rents, and equipment depreciation. Companies often seek tax deductions on allowable expenses to reduce taxable income and thereby lower their tax liability.
Key Takeaways
- Expenses represent costs a business incurs while operating to make revenue.
- Qualifying expenses can be written off on tax returns, contingent on meeting specific regulatory guidelines.
- Expenses are recorded using either cash basis or accrual basis accounting methods.
- Business expenses fall into two main categories: operating expenses and non-operating expenses.
- Capital expenses are handled differently in tax records, often spread over time.
Understanding Expenses
The overarching goal for any management team is to maximize profits by increasing revenue and controlling costs. Reducing expenses can increase the profitability of each sale; however, excessive cost-cutting might impede business growth and operational efficiency—such as slashing advertising budgets might limit a company’s market reach.
How Expenses Are Recorded
Income Statements and Accounting Methods
Companies detail their revenue and expenses in their income statements. Accountants use two main approaches to record expenses: the cash basis and the accrual basis.
Cash Basis: Expenses are documented when paid.
Accrual Basis: Expenses are recorded when incurred.
For example, scheduling a carpet cleaner for office cleaning would mean noting the cost on payment in cash basis accounting. Conversely, under the accrual method, the accountant notes the expense when service occurs.
It’s imperative that expenses recorded under the accrual method align with the reported revenues to maintain precise financial records.
Calculation of Net Income
Expenses are key to calculating net income. The simple equation involves subtracting expenses from revenues to determine net income.
Types of Business Expenses
Businesses typically categorize their expenses into two main groups:
Operating Expenses
Operating expenses are those tied directly to day-to-day business operations. This includes the cost of goods sold, office supplies, administrative fees, direct labor, and rent. Control of operating expenses ensures a healthier profit margin from core business activities; however, too much reduction can impact productivity and revenue generation.
Non-operating Expenses
These expenses are outside the primary business activities, such as interest charges or costs linked to loan payments. Non-operating expenses are crucial in determining how well the company performs in its main operations without the noise from peripheral costs.
Special Considerations
Capital Expenses
Capital expenditures (CapEx) relate to acquiring or upgrading physical assets like property, equipment, or technology. The IRS requires that capital expenses be capitalized rather than expensed in the year they are incurred, allowing businesses to write off portions of those investments annually over predetermined schedules.
Non-deductible Expenses
To be deductible, expenses must be deemed both ordinary and necessary by the IRS. Examples of non-deductible expenses include personal costs, lobbying expenses, penalties, and fines.
Examples of Expenses
Examples of typical business expenses cover a wide range including rent, utilities, wages, salaries, insurance, and goods procurement. These routine payments are essential to the continuous operation of a business.
What Are the Types of Expenses?
Expenses can fall into categories based on behavior—fixed or variable—or by their role in business activities—operating and non-operating. Fixed expenses include rent and mortgages, while variable expenses might encompass utilities and costs linked to production levels.
Is Salary Considered an Expense?
Yes, salaries are classified as an expense and are recorded as such on a company’s income statement.
The Bottom Line
Managing expenses is vital to business sustainability, influencing not just day-to-day operations but also tax obligations. Understanding and efficiently managing these costs enables companies to optimize profitability and compliance with tax regulations.
Related Terms: tax-deductible expenses, net income, capital expenditures, income statement.
References
- Internal Revenue Service. “Guide to Business Expense Resources”.
- Internal Revenue Service. “Tangible Property Regulations-Frequently Asked Questions”.
- Internal Revenue Service. “Tax Guide for Small Business”. Pages 30-39.
