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Expenses are the items on the Income Statement (a/k/a P&L – Profit and Loss statement) that reduce profit during the period of time that Income Statement covers.  So, many would think that an expense is simply anything that costs money.  But, of course, it’s not that simple. In fact, many items that reduce our cash are not expenses, and many expenses may not cost us any cash at all - at least not at the time that we book the expense.  Uh oh - more accounting confusion!  Let’s see if we can make this clearer:

It’s somewhat better to think of expenses as “costs of operating the business.” This still isn’t exactly right, but it helps. Here are a few examples:

• Rent, utilities, salaries, etc: these are the most straightforward expenses. We probably pay them when they come due, so indeed our cash is reduced by the amount of the expense. 
• Cost of Goods Sold: typically, these are our inventory costs. Note that buying the inventory is not an expense. Cost of Goods Sold (COGS) is the expense that comes from actually using (selling) the inventory.
• Depreciation & Amortization: these are expenses that don’t reduce our cash at all. Why? Because they are simply a recognition that a portion of the life of the assets that we own (and paid for some other time) have been used up.

When we buy assets of any kind - inventory, property, plant, equipment, prepaid expenses, etc - the cost is not an expense. Instead, we incur an expense when we use up the assets.

Stay tuned in coming weeks as we build on these concepts and discuss Expenses and Financing, Expenses vs. Liabilities, and Expenses vs. Capitalization. Better yet, sign up for one of our upcoming live, online, or on-demand courses for a more complete understanding!

There are many misconceptions about the Balance Sheet and its purpose. For example, the moment that one learns that assets on the Balance Sheet are generally valued at “historical cost” (i.e. what we paid for them) rather than “fair market value” (the current market price) for many may be the moment that they begin to give up on accounting. “The Balance Sheet doesn’t have the actual asset values on it? Then how do I know what the business is worth?” is a common refrain. In fact, not only are asset values on the balance sheet typically not updated to fair market value, but the values of other items such as the company’s brand(s), their relationships with suppliers and customers, and other intangible assets are generally not included at all. The complaints are correct: the Balance Sheet is generally not used to determine the value of a company. There are instead a variety of other valuation tools available, which we discuss in our Valuation programs.

Then is the Balance Sheet some antiquated holdover from less sophisticated times, a necessary evil but one that provides little utility?

If you look no further than determining valuation, you’ll miss out on the compelling story that the Balance Sheet tells about a company. The most important thing to understand about the Balance Sheet, and Accounting in general, is that it’s about dollars. Dollars that have come in to the company (and from where), and where they are now. Actual dollars as well as potential dollars the company expects to receive, such as from customers who purchased on credit. Under Liabilities and Owners’ Equity we find the sources of the dollars in the company - some dollars came from Equity, including dollars invested and profits earned, and some came from Debt and buying on credit. And what did we do with these dollars? Some dollars are still cash, some were “loaned” to our customers (so they could buy our products and services - those same dollars we expect to collect), and some were used to buy assets such as inventory and property, plant, and equipment.

So the Balance Sheet tells us the company’s financial condition at a given moment in terms of dollars - how many have come in and from where, and where they are now; how many of those dollars the owners can claim and how many dollars are owed to creditors. This is just part of the story, of course - join us for one of our upcoming live and online programs for much more.