Question and Answer: Expense
Q: What is an expense?
Money spent or cost incurred in an organization’s efforts to generate revenue, representing the cost of doing business.
Expenses may be in the form of actual cash payments (such as wages and salaries), a computed expired portion (depreciation) of an asset, or an amount taken out of earnings (such as bad debts). Expenses are summarized and charged in the income statement as deductions from the income before assessing income tax. Whereas all expenses are costs, not all costs (such as those incurred in acquisition of income generating assets) are expenses.
An expense can also be defined as a cost that occurs as part of a company’s operating activities during a specified accounting period. A retailer will likely incur the following expenses: the cost of goods sold, commissions earned by the sales staff, rent for the retail space, the cost of the electricity used, advertising that took place, wages and salaries that were incurred, etc.
Under the accrual method of accounting, an expense is reported on the income statement for the period when
1) the cost best matches the related revenues,
2) the cost is used up or expires, or
3) there is uncertainty or difficulty in measuring the future benefit.
For instance a retailer’s income statement for the month of July should report the cost of the goods that were sold in July. (The date that the retailer had paid for the goods is not relevant.) The commissions earned by the sales staff for having sold the goods in July is to be reported as an expense on the July income statement (even if the commissions are paid in September). The cost of the electricity used in July must also be included as an expense in the July income statement (even if the bill is received in September and is paid in October). These examples indicate that an expense can occur in an accounting period that is different from the period when the company pays for the item. Hence the word expense has a meaning that is different from payment.
Expenses are often divided into two major classifications: operating and non-operating. Operating expenses involve a company’s main activities. For example, a retailer’s operating expenses include
1) the cost of goods sold, and
2) the selling, general and administrative expenses.
The company may further sort these expenses by department, product line, and so on. A retailer’s non-operating expenses pertain to its incidental activities. A common non-operating expense for a retailer is interest expense.
In taxation, expenses is categorised into deductible and capital expenses
Deductible Business Expenses
According to the tax law, to be deductible, a business expense must be both ordinary and necessary. Ordinary means the expense is common or accepted in that industry, while necessary means the expense is helpful in the pursuit of earning income. Business owners are not allowed to claim their personal, non-business expenses as business deductions.
Capital Expenses
The tax law treats capital expenses differently than most other business expenses. While most costs of doing business can be expensed or written off against business income in the year they are incurred, capital expenses must be capitalized or written off incrementally over a period of time.
Capital expenses are typically large expenditures considered investments into a company. They include business start-up costs; business assets such as real estate, vehicles, equipment and patents; and improvements such as partitioning. Rather than writing off these expenses in the year they are incurred, business owners must write them off slowly over time.
The capital expenses are written off against the taxable income through capital allowances. The capital allowances are categorized into investment, initial and annual allowances. The tax authorities has rates that dictates the portion of a capital asset a business may write off each year until the entire expense is claimed. The number of years over which a business writes off a capital expense varies based on the type of asset.