I’ve lost count of the times a student has told me that an expense is cash paid, or that depreciation results in a cash payment. (“To whom?”, I always ask).
It’s not their fault. Expenses are a perfect illustration of how accounting uses common language in specific and uncommon ways.
I have found that students learn faster and more deeply when we dwell in the semantics—finding the time and space to be explicit and thoughtful about a transition from common usage to the accounting concept.
From their everyday lives, most students have a fairly clear idea of what expenses are. For example, mobile phone, rent, food, travel. Business expenses might include advertising, distribution, website hosting, energy, depreciation, wages and salaries, rent, and so on.
“And so on” in practice means listing examples in their hundreds, thousands, maybe hundreds of thousands. Examples are important but insufficient because they do not explain the inherent nature of expenses.
It is deceptively difficult to pin down what makes an expense an expense. The IFRS definition is fairly tortuous, so not a helpful learning aid, and in my experience, many accountants slip up once or twice on their way to an acceptable definition. Not because they don’t know, they simply haven’t carefully considered the language of expenses.
Expenses are activities that sacrifice or use up value.
Expenses are activities
Firstly, notice that expenses are described as activities. In UK charity accounting, the statement of profit or loss (or income statement) is the ‘statement of financial activities’. It’s a pity we don’t use that term more widely. It might clear up a lot of confusion.
Expenses are the actions of placing adverts, travelling to a client, moving goods around, heating a building. Initially, we therefore use verbs to describe expenses: advertising, travelling, distributing, heating.
Emphasising the fact that expenses are activities makes it clear that they are entirely different in nature to expenditure, which refers to the using up of cash.
Expenses are not the same thing as expenditure.
We need to be clear—expenses may use up cash. For example, cleaning that is paid for immediately is an activity that uses up cash. The important point is that the “using up of cash” is not the defining feature of expenses.
Confusion arises because, as with all transactions, two effects are recorded simultaneously: the activity of cleaning (increase expenses) and the using up of cash (decrease assets). You may need to remind students that we’re expressing the dual nature of the transaction: the essence of double-entry bookkeeping.
So, cleaning activity paid for with cash is an expense and it’s expenditure. But expenses also include activities that sacrifice value and do not use up cash. The following are examples of expenses that are not expenditure:
- “Cost of goods sold” records the activity of using up inventory;
- “Depreciation” is the activity of using up non-current assets;
- “Cleaning” services are provided and the cleaner leaves an invoice to be paid later.
Conversely, expenditure is not necessarily an expense. For example:
- Cash spent repaying a loan results in a decrease in liabilities—the bank loan is smaller.
- Cash used to purchase inventory: the inventory sits on the shelf—it is valuable, it is an asset.
Being able to distinguish expenditure from expenses is a vital accounting skill.
Expenses sacrifice or use up value
We know that only assets are valuable. So, the claim that expenses are activities that sacrifice value means that expenses are activities that decrease the value of assets. As we have seen, the asset may be cash, but other times it may be inventory, equipment or something else altogether.
The idea that expenses change the value of assets is an important one and supports the notion that expenses are activities, that is, they are actions, they have an effect.
It’s worth making the point that expenses may not immediately reduce the value of assets, but instead increase liabilities. For example, cleaning services provided on credit. The expense is recognised at the time of activity: when the cleaning services are provided. The simultaneous effect (the double-entry) recognises the obligation to pay the supplier in the future: increase liabilities.
Only when cash is paid to the supplier will the value of assets decrease. The payment to the supplier, of course, is not an expense: cash is used up (assets decrease) and the obligation is settled (liabilities decrease).
Taking the possibility of an increase in liabilities into account allows the definition to be developed: expenses are activities that use up the value of net assets (assets less liabilities). A decrease in assets is a decrease in net assets. An increase in liabilities is also a decrease in net assets.
It’s then a small step to remind students that net assets are equivalent in amount to equity. At this point, the IFRS definition starts to make some sense.
The necessity of expenses
Although expenses use up the value of assets, they are necessary—without expenses there is no business. There are exceptions but expenses support and enable a business to generate revenue. The “value generating machine” of business combines activities that consume value (expenses) and activities that generate value (revenue or income).
Although they destroy value, expenses are incurred to enable activities that generate value.
The responsibility of directors of profit-centric entities is to govern activities such that value is created—that is, to generate profit. In the context of a profit motive, expenses are justifiable on the basis that they are expected to generate more value than they destroy. For example, advertising activity that cost £1m clearly uses up value of £1m. This may or may not be a wise decision, but if it results in sales activity that generates profits of more than £1m, the expense is the primary cause of an overall increase in value.
Some students (and business leaders, politicians and others) are often inclined to over-simplify the profit objective as a principle of minimising expenses and maximising income. It is not the aim of even profit-centric entities to reduce their expenses, but to incur them in a way that creates most value. Sometimes expenses aren’t high enough to allow an entity to function effectively.
 “Decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims.” IFRS Conceptual Framework 2018, Para 4.2
 Exceptions include expenses incurred as a result of the misappropriation of assets either accidentally or intentionally.
 The scope and extent of this responsibility is controversial and hotly debated. Some economists suggest that, subject to acting within the law, generating profit is the primary or only responsibility of companies. Others believe that the responsibility to generate profits must be balanced against other competing objectives, such as environmental and social concerns.