The nature of expenses

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 perfectly illustrate how accounting uses everyday 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 transitioning from everyday usage to the nature of expenses in an accounting context.

From their personal experiences, students have an intuitive idea of the nature of expenses — for example, mobile phone, rent, food, and travel. Business expenses might include advertising, distribution, website hosting, energy, depreciation, wages and salaries, rent, and so on.

“And so on” means listing examples in their hundreds, thousands, maybe hundreds of thousands. Multiple examples are essential but insufficient because they do not explain the inherent nature of expenses.

It isn’t easy to pin down what makes an expense an expense. The IFRS definition is somewhat tortuous [1], 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 but because they haven’t considered the language of expenses carefully.

The Joy of Accounting [2] provides a useful starting point:

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 actions such as placing adverts, travelling to a client, moving goods around, and heating a building. Initially, we use verbs to describe expenses, emphasising the “—ing”: advertising, travelling, distributing, heating.

Explaining that expenses are activities makes clear that they are entirely different from expenditure, which refers to using cash.

Expenses are not the same thing as expenditure.

We need to be precise — expenses may use up cash. For example, cleaning that is paid for immediately is an activity that uses up cash. The critical 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 action of cleaning (increase expenses) and the depletion 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 an expenditure. But expenses also include actions that sacrifice value and do not use up cash. These are 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, and 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 [3], 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 profit-seeking entities is to conduct activities that create value — that is, to generate profit [4]. 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 costs £1m clearly uses up a 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 inclined to over-simplify the profit objective minimising expenses and maximising income. It is not. The aim is to incur expenses in a way that creates the most value. Sometimes expenses aren’t high enough to allow an entity to function effectively.

Part of the Concepts series of articles

© AccountingCafe.org

Notes and further reading

[1] “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

[2] Frampton, P. and Robilliard, M. (2020) The Joy of Accounting. London: Wealthvox Press.

[3] Exceptions include expenses incurred as a result of the misappropriation of assets, either accidentally or intentionally.

[4] The 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.