Expense: Definition, Types, and How Expenses Are Recorded

What Is an Expense?

An expense is the cost of operations that a company incurs to generate revenue. It is simply defined as the cost one is required to spend on obtaining something. As the popular saying goes, “it costs money to make money.”

Common expenses include payments to suppliers, employee wages, factory leases, and equipment depreciation. Businesses are allowed to write off tax-deductible expenses on their income tax returns to lower their taxable income and thus their tax liability. However, the Internal Revenue Service (IRS) has strict rules on which expenses businesses are allowed to claim as a deduction.

Understanding Expenses

One of the main goals of company management teams is to maximize profits. This is achieved by boosting revenues while keeping expenses in check. Slashing costs can help companies to make even more money from sales.

However, if expenses are cut too much it could also have a detrimental effect. For example, paying less on advertising reduces costs but also lowers the company’s visibility and ability to reach out to potential customers.

How Expenses Are Recorded

Companies break down their revenues and expenses in their income statements. Accountants record expenses through one of two accounting methods: cash basis or accrual basis. Under cash basis accounting, expenses are recorded when they are paid. In contrast, under the accrual method, expenses are recorded when they are incurred.

For example, if a business owner schedules a carpet cleaner to clean the carpets in the office, a company using the cash basis records the expense when it pays the invoice. Under the accrual method, the business accountant would record the carpet cleaning expense when the company receives the service. Expenses are generally recorded on an accrual basis, ensuring that they match up with the revenues reported in accounting periods.

Types of Business Expenses

There are two main categories of business expenses in accounting: 

Operating Expenses

Operating expenses are the expenses related to the company’s main activities, such as the cost of goods sold, administrative fees, office supplies, direct labor, and rent. These are the expenses that are incurred from normal, day-to-day activities.

Operating expense is deducted from revenue to arrive at operating income; the amount of profit a company earns from its direct business activities. Companies need to manage their operating expenses to ensure that they are maximizing profits; this is usually done by keeping expenses at a minimum; however, reducing expenses too much can reduce the company's productivity.

Non-operating Expenses

Non-operating expenses are not directly related to the business's core operations. Common examples include interest charges and other costs associated with borrowing money. These are expenses that occur outside of a company's day-to-day activities. These costs may occur from restructuring, reorganizing, interest charges on debt, or on obsolete inventory.

Non-operating expenses are separate from operating expenses from an accounting perspective so as to be able to determine how much a company earns from its core activities.

Special Considerations

Capital Expenses

Capital expenditures, commonly known as CapEx, are funds used by a company to acquire, upgrade, and maintain physical assets such as property, buildings, an industrial plant, technology, or equipment.

The IRS treats capital expenses differently than most other business expenses. While most costs of doing business can be expensed or written off against business income the year they are incurred, capital expenses must be capitalized or written off slowly over time.

The IRS has a schedule 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.

Not All Expenses Can Be Deducted

According to the IRS, 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. They also cannot claim lobbying expenses, penalties, and fines.

The Bottom Line

An expense is a cost that businesses incur in running their operations. Expenses include wages, salaries, maintenance, rent, and depreciation. Expenses are deducted from revenue to arrive at profits. Businesses are allowed to deduct certain expenses from taxes to help alleviate the tax burden and bulk up profits.