What Are Expenses? Definition, Types and How They Are Recorded

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An expense is a cost a business incurs in the process of earning revenue during a period. Rent, wages, utilities, the cost of goods sold, interest on loans and depreciation are all expenses. In accounting, expenses are reported on the income statement, where they are subtracted from revenue to arrive at profit, and every expense reduces the owners’ equity in the business.

What counts as an expense in accounting

An expense is not simply money leaving the bank account. It is the consumption of something of value (labor, space, inventory, electricity, the useful life of a machine) in a specific period. That definition explains several cases that confuse readers:

• A salary is an expense. Wages and salaries are reported as expenses on the income statement for the period in which employees did the work.
• Depreciation is an expense even though no cash moves. The cash left when the equipment was bought; depreciation spreads that cost across the years the equipment is used.
• Prepaying rent is not yet an expense. Paying twelve months of rent in advance creates a prepaid asset. Each month, one-twelfth of it is moved to rent expense as the space is used.
• Repaying a loan’s principal is not an expense. It reduces a liability. Only the interest portion is an expense.
• Owner withdrawals and dividends are not expenses. They are distributions of profit, not costs of earning it.

The related words have narrower or broader meanings. A cost is the amount paid or given up for something, whether or not it has been used yet. An expenditure is an outlay of money, which may buy an asset or pay an expense. An expense is the portion of cost that has been used up and charged against revenue.

How expenses are recorded

Cash basis vs. accrual basis

The accounting method decides when an expense appears in the books.

• Cash basis: the expense is recorded when it is paid.
• Accrual basis: the expense is recorded when it is incurred, meaning when the goods or services are received, regardless of when the bill is paid.

Hypothetical example: a company has its offices cleaned on December 20 and pays the $1,500 invoice on January 10. Under the cash basis, the expense falls in January. Under the accrual basis, it falls in December, the month the company received the service.

Accrual accounting is the standard under GAAP and IFRS because it follows the matching principle: expenses are recognized in the same period as the revenues they helped produce, giving a truer picture of profit for each month, fiscal quarter or year. Cash accounting is simpler and is used mainly by small businesses and individuals.

The journal entry

In double-entry bookkeeping, an expense is recorded with a debit to an expense account (for example, Rent Expense or Wages Expense) and a credit to either Cash, if paid immediately, or Accounts Payable, if the bill is still owed. Expense accounts are temporary. At the end of the period they are closed out to retained earnings, which is how expenses reduce equity on the balance sheet.

Types of expenses

Operating expenses

Operating expenses arise from a company’s normal, day-to-day business. Common examples:

• Cost of goods sold, including direct materials and direct labor
• Rent and utilities
• Salaries and wages
• Office supplies and administrative fees
• Marketing and advertising
• Insurance and maintenance
• Depreciation of operating assets

Subtracting operating expenses from revenue gives operating income, the profit generated by the core business.

Nonoperating expenses

Nonoperating expenses come from activities outside the company’s main operations. The most common is interest on debt and other borrowing costs. Others include losses on investments, restructuring or reorganization charges, and write-downs of obsolete inventory. They are reported separately so that readers can see how much the business earns from its core activities before financing decisions and one-off events.

Fixed and variable expenses

Expenses can also be grouped by how they behave as activity changes:

• Fixed expenses stay the same regardless of output within a normal range, such as rent or a mortgage payment.
• Variable expenses rise and fall with production or sales, such as raw materials, cost of goods sold and production-related utilities.

Some costs are semi-variable, with a fixed base plus a usage component, such as a phone plan with overage charges.

Worked example: from revenue to profit

Hypothetical figures for a small manufacturer for one year:

Total operating expenses are $405,000. Adding interest, total expenses before tax are $413,000. The core formula is the same at every level:

Net income = Revenue − Expenses

If the company had wrongly expensed a $50,000 machine instead of capitalizing it, operating income would fall to $45,000 in year one and every later year would be overstated.

Capital expenditures and why they are not expensed immediately

Capital expenditures (CapEx) are funds spent to acquire, upgrade or maintain physical assets such as buildings, plant, equipment or technology. Because these assets serve the business for years, their cost is capitalized: recorded as an asset on the balance sheet and expensed gradually through depreciation over its useful life.

For tax purposes, the IRS likewise recovers capital expenses over time on a schedule that depends on the type of asset, while most ordinary costs of doing business can be written off in the year they are incurred.

Tax deductibility of business expenses

Businesses can deduct qualifying expenses on their income tax returns, which lowers taxable income and tax owed. The IRS requires that a deductible business expense be both ordinary (common and accepted in that industry) and necessary (helpful and appropriate for earning income). Some items cannot be deducted:

• Personal, nonbusiness expenses
• Lobbying expenses
• Penalties and fines

An expense recorded in the accounting books is not automatically deductible, and the timing of book and tax recognition can differ.

Limitations of expense figures

Reported expenses involve judgment, and that affects how they should be read:

• Classification choices. Whether a cost is operating or nonoperating, or capitalized or expensed, changes operating income and margins even when total spending is the same.
• Estimates. Useful lives for depreciation and accrued bills not yet received are estimates. Different assumptions produce different expense totals.
• Non-cash items. Depreciation and other non-cash expenses reduce profit without reducing cash in that period, so expenses and cash outflows can diverge.
• One-time charges. Restructuring costs or write-downs can make a single period look unusually weak.
• Lower is not always better. Cutting the wrong expense can hurt revenue. Reducing advertising lowers costs today but also reduces the company’s visibility to potential customers.

FAQs

The Bottom Line

Business owners, bookkeepers and anyone reading an income statement need to know what counts as an expense and when it is recorded. Classification and timing choices, such as capitalizing a machine or expensing it, can shift operating income sharply between periods. Reported expense figures rest on judgment and estimates, so they should be read alongside cash flows and with one-time charges in mind.