Definition
An expense is a cost that a business incurs as part of its operations to generate revenue. Expenses are essential for daily functioning and are recorded on a company’s income statement. They are deducted from the total revenue to calculate net income.
Common examples include rent, salaries, utilities, insurance, depreciation, and the cost of goods sold (COGS).
How Expenses Work
Expenses represent the outflow of money or other assets from a company in exchange for goods or services used in its operations. They directly impact a company’s profitability and are critical in financial reporting and tax calculations.
Businesses aim to manage expenses efficiently to optimize profit margins. While necessary to operate, excessive or poorly controlled expenses can erode profits and strain cash flow.
Recording Expenses
Expenses are recorded using one of two accounting methods:
- Cash Basis Accounting: Expenses are recorded when payment is made.
- Accrual Basis Accounting: Expenses are recorded when they are incurred, regardless of when payment is made.
For example, if a company receives maintenance services in December but pays the invoice in January, the expense is recorded in December under accrual accounting.
Expenses appear on the income statement, grouped by type, and are used to calculate net income:
Net Income = Revenue – Expenses
Types of Business Expenses
| Category | Description |
| Operating Expenses | Costs associated with core business operations include salaries, rent, and utilities. |
| Non-Operating Expenses | Expenses not directly tied to business operations, like interest payments or restructuring costs. |
| Fixed Expenses | Costs that remain constant regardless of output (e.g., rent, insurance). |
| Variable Expenses | Costs that fluctuate with production or sales (e.g., raw materials, shipping). |
| Capital Expenditures (CapEx) | Long-term investments in assets such as property or equipment. Treated differently for tax and accounting purposes. |
Special Considerations
Capital Expenses: Unlike regular operating expenses, capital expenses are treated as investments in long-term assets. Instead of being expensed immediately, they are capitalized and depreciated over time according to IRS guidelines. This affects how they appear on financial statements and how they’re treated for tax purposes.
Tax Deductibility: Most business expenses are tax-deductible if considered “ordinary and necessary” by the Internal Revenue Service (IRS). These must be common in the business industry and essential for operations. Examples of non-deductible expenses include:
- Personal expenses unrelated to business
- Fines and penalties
- Political contributions or lobbying costs
GAAP Documentation Requirements
Under GAAP, businesses must ensure that all expenses are accurately recorded and substantiated to reflect an accurate and fair view of the company’s financial position. Core principles include:
- Expense Recognition: Expenses should be recognized in the period in which they are incurred, matching them with the revenues they help to generate.
- Audit Trail: Maintain detailed records that provide a clear audit trail, including invoices, receipts, and contracts, to support each expense entry.
Proper documentation under GAAP facilitates internal decision-making and ensures transparency and reliability in financial reporting, which is essential for stakeholders and regulatory bodies.
IRS Documentation Requirements
The IRS mandates that businesses keep adequate records to substantiate expenses claimed as deductions. Essential documentation includes:
- Receipts and Invoices: Documents should clearly show the amount paid, date, place, and nature of the expense.
- Proof of Payment: Canceled checks, credit card statements, or electronic funds transfer confirmations that verify the expense was paid.
- Business Purpose: A written explanation of the business purpose for the expense, especially for travel, meals, and entertainment.
For expenses under $75, the IRS may not require a receipt; however, maintaining detailed records is advisable to substantiate such expenses. citeturn0search0
Record Retention Period
The IRS generally requires businesses to retain expense records for at least three years from the date the tax return was filed. However, certain circumstances may necessitate longer retention:
- Six Years: If income is underreported by more than 25%.
- Seven Years: For claims of worthless securities or bad debt deductions.
Maintaining organized and comprehensive records aids in tax compliance and prepares businesses for potential audits.
For detailed guidance, refer to the IRS resource on recordkeeping.
Adhering to these documentation practices ensures compliance with GAAP and IRS regulations, supports accurate financial reporting, and substantiates deductions during tax filings.
Examples of Expenses
- Rent paid for office space or facilities
- Employee wages and salaries
- Utilities such as electricity and water
- Maintenance and repairs for business property
- Depreciation on capital assets
- Inventory costs (cost of goods sold)
- Marketing and advertising expenditures
Expenses are fundamental to any business. They represent the costs necessary to maintain operations and generate income. Accurately recording and categorizing expenses is essential for financial analysis, budgeting, tax reporting, and strategic planning. Businesses that actively monitor costs are better positioned to manage profitability, sustain growth, and maintain financial health.
