Expenses, or operating expenditure, are payments or outflows of economic benefits from a business to pay for the day-to-day running costs incurred as a result of transactions that have already taken place. You will notice how we define expenses is quite particular in accounting and below we’ll look at why this language is used.
Examples of expenses often incurred by firms would be for rent, insurance, wages, taxes, power bills, etc.
Although required in the running of a business they reflect a reduction in the net assets or net worth of the firm. Unlike purchasing assets, that initially generally are neutral on net worth and income, where it increases net worth.
An important to point to remember as we move through these short tutorials is that expenses may or may not be a cash transaction. We’ll look at a couple of examples in the accounting entries below to make the point. For example, if a firm pays a contractor to fix one of its machines and pays them cash, that would be an increase in maintenance costs with a corresponding decrease in bank. While the same transaction could take place with the contractor say extending credit to the firm and so the increase in expense would then see an increase in liabilities, rather than reduction in cash.
So we have looked at how we define expenses, why those particular words are used. Next lets take a look at the accounting entries and how expenses change the accounting equation.
The Accounting Equation and Entries
The accounting equation provides an excellent tool for helping to explain how accounting transactions impact on business. And understanding how in double-entry accounting keeping the equation in balance ensures inflows and outflows are correctly recorded.
So to recap. The accounting equation must be kept in balance at all times as it reflects the only ways economic benefits flow into and out of a business. On the left side of the equation we have all of the ways in which a business can consume economic benefits: buying assets, spending on expenses or make drawings form the business. And on the right side are the three ways in which a business can bring economics benefits in: borrow funds, earn revenue or introduce capital.
Paying Expenses by Cash
In this first transaction ABC Ltd is paying for some machinery repairs with cash. This means we are going to be dealing with an expense account and the bank account. Using the accounting equation that would look like this:
Of course we can’t record a business’ transactions using the accounting equation. So we use the debits and credits of the double-entry system. As we are increasing the amount we spend in an expense account, ie machinery repairs, we have to debit that account with $100. And as we are dealing with the bank account, which is an asset, we have to credit this account to reduce its balance.
|March 20||Machinery Repairs||$100|
But what about when we incur some expenses but can out it on credit, say until month-end, and not pay out cash straight away? In that case we have change where the credit entry goes. As we aren’t dealing with the bank account in this case, but rather creditors – which is a liability account sitting on the other side of the accounting equation. You can see below that the equation is still in balance as we have + $100 on both sides, rather than the + and – on the left side.
Paying Expenses by Credit
And the double-entry accounting entries would be:
|March 20||Plant Machinery||$100|
You can see from both entries that expenses are still incurred by the firm, but in the first cash is used to pay for the repairs while in the second the firm incurs debt, ie it owes XYZ for the work carried out.
We trust we have been able to help with a better understanding of expenses and how the debits and credits are treated in an accounting system. From these basic transactions you can see how important it is that the correctly define expenses and understand their impact upon the accounting equation. If you understand how a transaction sits in the equation the debits and credits are then generally quite straight forward.