The American Accounting Association defines accounting as a process of working with economic information in a way that ultimately permits users to make informed judgments and decisions. Business expense transactions are an integral part of the process and, because they represent part of the cost of doing business, are an inevitable part of a business’s quest for profit. Expenses are not the same as costs, but not all new business owners understand the difference between them.
An expense is a cash payment, the portion of an asset used up during an accounting period or an item that directly reduces revenue. Examples include wages, supplies and rent payments; depreciation attributed to a piece of equipment or a vehicle; and a bad debt write-off. At the end of an accounting period, expenses are totaled, deducted from revenue and used to calculate net profit on an income statement. Expenses are not the same as costs; while all expenses are costs, not all costs are expenses. For example, cash paid to reduce the balance of a loan is not an expense because, while the payment itself reduces cash, the effect of the payment directly reduces a business liability rather than reducing revenue.
Accounting for expenses follows the debt-credit matching principle of accounting. A debit entry signals an increase in an expense, while a credit entry signals a decrease. In double-entry bookkeeping, a debit goes on the left and a credit on the right. When recording a $4,000 depreciation transaction, for example, a $4,000 debit to depreciation expense will increase depreciation expense and a corresponding $4,000 credit to the asset will decrease the value of the asset by $4,000. Because expense accounts rarely decrease, the normal balance of an expense account is a debit balance. Keep this in mind when the books don’t balance and you need to start checking for errors.
Prepaid expenses are payments made in advance of the due date or dates and reduced as the payment date or dates arrive. A business may, for example, prefer to make a single yearly payment of $4,800 for insurance rather than regular monthly payments of $400. The general journal accounting transaction at the time the business makes the payment will show as a debit of $4,800 to prepaid insurance -- an asset account -- and a $4,800 credit to cash. An adjusting journal entry at the end of each month will debit or increase the Insurance expense account and credit or decrease the prepaid insurance asset account by $400.
A second category of expenses recognizes expenses a business incurs but does not immediately pay. Common examples include wages, interest on a bank loan and taxes. Because accounting rules require the transaction to be recorded at the time the business incurs the expense, a debit to the expense account will increase wages, interest or tax expenses, and a credit to the wages, interest or tax expense payable liability account will record the liability amount. Payments made later affect the expense payable liability and cash accounts but do not affect the expense account, because the expense has already been recorded.