Expense is what a business incurs to produce and deliver its services and thereby earn revenue. It is therefore part and parcel of every enterprise. Expenses are usually of three types:
- Operating Expenses
- Capital or Investment Expenses
- Financial Expenses
1. Operating expenses are those that the business incurs to create and deliver the product or service. These are typically those expenses that deliver their value within a short period of time. For example: Salaries of employees is a monthly operating expense. It delivers its value namely employee effort in that very month. Other examples of operating expenses include rent of office and/or factory, utility bills (electricity, telephone, conveyance) etc.
2. Capital Expenses are those that result in the business gaining benefits over a longer period of time. For example: Purchase of expensive machinery that has a life of 10 years. Such a machine may incur a huge cost that may have to be funded through a loan if the business does not have enough internally generated funds. In any case accountants amortize the expense over the ten years to reflect the usage of the machine by the business. Other examples of capital expenses include land, machines, computers, furniture, etc. Based on the possible life of the asset, the expense is proportionally amortized. Amortization means dividing the cost of the asset across its useful life in proportion to its utilization.
3. Financial Expenses are those that the business incurs to ensure that the operating and capital expenses are paid for. Examples of financial expenses are interest on loans or debt. Loans may be short term and long term in nature. Dividends paid to owners are not an expense to the company.
Expenses are incurred by the business so as to generate revenue. Hence when an expense is made it normally is deducted from the revenue in the Income Statement (https://rajshankar.wordpress.com/2013/11/01/finance-for-entrepreneurs-what-is-a-profit-loss-statement/ ). If the expense is of a capital nature, then the expense is first taken to the Balance Sheet as an asset and based on the life of the asset a small portion of that spending is brought to the Income statement at the end of the year as an expense for that Operating Period. Financial expenses typically affect the Balance Sheet (https://rajshankar.wordpress.com/2013/11/08/finance-for-entrepreneurs-what-is-a-balance-sheet/ ) first as an increase of liability of reduction of asset. Interest paid on debt is typically brought to the Income Statement for the relevant accounting period as an expense.
Let us take a more detailed look at expenses and their impacts on the financial statements in a later lesson. But for now try to understand what these expenses are and how these are different from each other.
Try it: Ask your accountant for a copy of your latest Income Statement and try to segregate the expenses based on the above three types.