Expense

Expense: Definition, Types, and How It’s Recorded

Key takeaways
* An expense is a cost a business incurs to generate revenue.
Expenses are recorded under either cash-basis (when paid) or accrual-basis (when incurred) accounting.
Major classifications include operating vs nonoperating expenses and capital expenditures (CapEx), which are capitalized and depreciated.
* For tax deductibility, expenses must generally be “ordinary and necessary”; personal costs, lobbying, and penalties are typically nondeductible.

What is an expense?
An expense is any cost a business incurs as part of running its operations or producing income. Common examples include rent, wages, utilities, supplies, insurance, depreciation, and the cost of goods sold.

Why expenses matter
Managing expenses is essential to maximizing profit. Revenues minus expenses equals net income. Reducing costs can increase profit, but cutting too deeply (for example, slashing advertising) can harm future revenue generation. Many business expenses are tax-deductible, which lowers taxable income, but tax rules limit what can be claimed.

How expenses are recorded
Businesses use two primary accounting methods:
* Cash-basis accounting: record an expense when cash is paid.
* Accrual-basis accounting: record an expense when the obligation is incurred, regardless of payment timing.

Example: If a company schedules carpet cleaning, a cash-basis accountant records the expense when the invoice is paid; an accrual-basis accountant records it when the service is received. Accrual accounting is commonly used to match expenses with the revenues they help produce.

Types of expenses
Operating expenses
* Related to a company’s core business activities and day-to-day operations (e.g., cost of goods sold, salaries, rent, office supplies, administrative costs).
* Deducted from revenue to compute operating income.

Nonoperating expenses
* Not directly tied to core operations (e.g., interest expense, losses from asset sales, restructuring costs).
* Reported separately so users can see earnings from core activities.

Other categorizations
* Fixed expenses: do not vary with production levels (e.g., rent, lease payments).
Variable expenses: fluctuate with production or sales volume (e.g., raw materials, production labor).
Salaries and wages: treated as operating expenses and recorded on the income statement.

Capital expenditures (CapEx)
Capital expenditures are amounts spent to acquire, upgrade, or extend the useful life of long-term assets (property, plant, equipment, major software). Unlike ordinary operating expenses, CapEx is capitalized and written off over time through depreciation or amortization according to applicable tax and accounting rules.

Tax deductibility
To be deductible for tax purposes, a business expense generally must be ordinary (common in the industry) and necessary (helpful and appropriate for the business). Personal expenses, lobbying costs, fines, and penalties are generally nondeductible. Specific rules and depreciation schedules apply to capital assets.

Common examples of expenses
* Rent and utilities
Employee wages and benefits
Cost of goods sold and raw materials
Maintenance and repairs
Depreciation and amortization
Insurance and professional fees
Interest expense

Net income formula
Net income = Revenues − Expenses

Bottom line
Expenses are the costs of operating and growing a business. Proper classification (operating vs nonoperating, expense vs capital) and accurate recording (cash vs accrual) are vital for financial reporting and tax compliance. For questions about deductible expenses or capitalized costs, consult an accountant or tax professional.