Financial Accounting

Elements of Financial Statements part 5 – Expense

What can be recorded as expense in business?

As per IASB(2020),” Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.” (IASB, 2020)

Not all Cash outflows and monies spent for business are recorded as expenses and presented in Income statement to calculate profit (or loss) as business expenditures are categorised into two areas:

  • Capital expenditures
  • Revenue expenditures

Capital Expenditures

When a business invest money in a non-current asset, it will be considered as a capital expenditure rather than an expense and the main reason for this is the longer life (more than 12 months) of the assets. These are usually big payments which are not incurred every year and would be recorded in Balance Sheet.

Income statement only shows the expenses which were incurred to earn the revenues in that year. However, as the benefits of capital expenditures last for more than a year, only a part of these in income statement as an expense known as “Depreciation”. depreciation is a process of spreading/matching the cost of an asset over its useful life. It is associated with tangible assets, however, if an asset is intangible, it is called “amortisation” of the assets. Both of these are included in the income statement as expense. There are two fundamental accounting concepts which are in operation here, “Accrual Concept” and “Matching Concept”.

Accrual Concepts states that we will record all those expenses which were incurred (regardless of the fact that a cash payment has been made or not) to earn those revenues/sales.

For example, if goods were bought on 25th December on one-month credit and were sold before 31st December in the same year, the cost of buying those goods would be recorded as cost of those goods even a payment has not been made.

The matching concepts extends the accrual concept and says that only those expenditures will be shown in the income statement which relate to earning the revenues in that year. These expenditures may have been paid for in the same year, in the past or in future (as we discussed in our section on “transaction”.)

If part of an item of expenditure has been paid for but has not been used in that year, that part will be excluded from costs/expenses for that year. As assets are used to generate revenues for the longer term, therefore, only that part of the money spent on assets should be included in income statement which was used in that year.

For example, an oil company spent £50 million (capital expenditures) in oil exploration and was successful in finding an oil reserve with an annual output of worth £20 million (after deducting the cost of extraction) for the next 10 years. If we add all of the £50 million in income statement as an expense, we will not be matching the expenses of findings the oil over the life of the oil well and our income statement would look like below in the first 4 years.

Matching concept states that the cost of £50 million should be matched reasonably (equally in this case as production will be consistent) to the life of the assets. The income statement would look like below in that case;

The total cost of finding the oil reserve has been distributed over the life of the asset (£50m/10 years) as £50 million was invested for the life of the assets not just for the first year. The part of investment of £50 million which is being expensed (£5million) in the income statement depreciation of the initial capital expenditures.

Revenue Expenditures / Expenses

All expenses which can be related (directly or indirectly) to the revenues earned in the same year are categorised as revenue expenditures and presented in income statement. Those related directly to the revenues are called “cost of goods sold (CGS)”. For example, if a business buys a product for £5 a unit and sells it for £10 a unit, the CGS would be £5 or 50% of sales. However, a business would need to incur other costs (indirect costs) as well in order to sell those goods e.g. shop rent, staff salaries, depreciation on assets etc. These costs are called “operating costs”.

Expenses are usually the biggest head of account in any businesses’ accounting records with 100s or may be 1000s of sub accounts. There could be as many examples for these expense accounts but few are given below;

  • Purchases
  • Rent & rates
  • Wages and salaries
  • Utilities etc

These expenses are categorised as per their nature of direct or indirect expenses into “cost of sales” and operating expenses. We will discuss these concepts in more detail in “Profitability Ratios”.

Below is the actual data on Burberry’s “Cost of sales” and “Operating expenses” from its statement of Profit & Loss (Income Statement)” for the year ending 28 March 2020. 

Note 3 gives a more detailed version of operating expenses which we will discuss in detail in the ratios where this figure is needed.

This article is written by Raja Mizan who is a senior lecturer in accounting & finance in a UK university. He is an ACCA member and also runs his own accountancy practice RMR Accountants & Business Advisors.

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