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An expense reduces our profit in recognition of some business cost. Simple enough. The tricky thing is what do we consider business costs?

Let’s take inventory for a moment. Is buying inventory a business cost? It does cost us some money (now, or later if we’ve purchased on credit). However, we still have the inventory once it’s been purchased, and it is listed as an asset on our Balance Sheet. Though we’ve converted money into inventory, we don’t consider it a cost because we still have the inventory. It becomes a cost when we actually use the inventory - it’s the Cost of Goods Sold expense. Similarly, when we buy a piece of equipment, we still have it. A year later, the equipment is (likely) still in operation. We don’t consider the purchase of the equipment to be a cost. We consider the actual usage of the equipment (or simply the fact that it has become a year older) to be the expense. More on this in a future article.

What if we pay for a multi-year service contract? Same concept applies - it becomes an expense when we actually use up the contract. When we buy the contract, its value becomes an asset on our Balance Sheet, which is then reduced as we use (and actually expense) the service.

Let’s go one step further. What if we’re paying employees (or contractors, etc) to build something for us. Perhaps it’s a building. Maybe it’s an improvement to an existing building. Or it may be software that we’ll be using for years to come. We’re paying people - sounds like a wage expense, right? But like the items above, we still have these assets after we’ve paid for them. And like the items above, they’ll become expenses as we use up their useful life. In the meantime, we capitalize these expenses; in other words, we treat them just like the purchase of any other assets, and they are listed on our Balance Sheet.

Soon we’ll discuss the sort of expenses these types of assets create, as well as the true nature of expenses. If you find these pointers to be useful, imagine the value you’ll get from taking one of our courses!

Now we’re not making any sense, right?  Liabilities and expenses are both things you have to pay for – why aren’t they the same, you might wonder. 

Recently we have been taking a look at expenses - what they are (costs of operating the business), how they may be used to…adjust…corporate earnings (by varying estimates and accounting choices), and how they relate to loan payments (paying down principal is NOT an expense, but interest is an expense).  So what about liabilities?

Liabilities are what we owe - to lenders and anyone who has sold us goods or services on credit - suppliers, professionals, etc. If we pay for our expenses when they come due, or in advance (we pay the rent when it’s due, we buy inventory for cash, we prepay for insurance), then those expenses never become liabilities.  If we’ve paid for them on credit, then those expenses generate liabilities because we still owe them, not simply because they are expenses.  And if we have a liability because we need to repay money we’ve borrowed, then as discussed in a recent article, those repayments are not expenses.

Looking at it another way, expenses are items that happen in time and liabilities are persistent.  An expense happens in a moment - the rent comes due, interest comes due, we use a service, or it’s payday.  We then add the expenses to our Income Statement (a/k/a P&L Statement, or Profit & Loss).  If we pay for them at the time, or prepaid for them, then that’s it – they never become liabilities.  If we haven’t paid for them yet, then they create liabilities related to those expenses – but those liabilities are not the expenses themselves.  Liabilities persist for a period of time – they’re created when the bill comes due, or we borrow money, and they go away once the bills are paid or the debt is repaid.

More confused than ever?  We hope not! It sounds a lot more complicated than it really is.  Stay tuned as we look further at Expenses vs. Capitalization and the true nature of expenses.  Better yet, sign up for one of our upcoming live, online, or on-demand courses for a more complete understanding!

Ever wonder why certain public companies meet or beat the earnings number predicted by Wall Street research analysts? GE, Microsoft, Apple are just a few of many corporate behemoths that tend to impress analysts and investors quarter after quarter. So how are they able to consistently able to beat these numbers, even in a slow economy? Two factors contribute to this:

1. Guidance
2. Profit Smoothing

As much as we would like to believe that the stars align for such companies, the reality is that managing earnings is more a product of skill than divine intervention.

When it comes to guidance, corporate managers tend to under-promise and hope to over-deliver. It works something like this: Company X just released its quarterly earnings report and beat the consensus earnings number. The consensus number is the average of analysts’ prediction for net earnings (also referred to as net income, net profit or the bottom line). Company X was pleased to report that due to aggressive cost cutting, they were able to beat the consensus number by one penny per share (total net earnings divided by total shares of stock outstanding). Beating the estimate is always a good thing and will often drive the stock price higher. While analysts and investors rejoice, the corporate management pats itself on the back for achieving strong results.

So how did they pull this off? At the conclusion of last quarter, Company X purposely issued very conservative earnings guidance even though there were several large sales likely to close before the end of the quarter. To play it safe, they sought to keep expectations low knowing they could easily surpass them and push the stock price higher.

As it turned out, several of the planned sales fell through. Time to bring in the heavy artillery. In this case, the heaviest of all is profit smoothing. Company X can adjust the assumptions on non-cash gains and expenses to make the earnings number beat expectations. Still too low? Why not lower the charge against a bad loan portfolio? How about changing the depreciation schedule to lower the expense taken in the near term? Through some combination of non-cash adjustments, Company X is able to generate the right earnings number. Unfortunately, once in a while no amount of profit smoothing will save a company from a bad earnings number which is what happened to GE a few quarters ago. And when that happens, look out below!

Recently we began a discussion about expenses: what are expenses - and what are they not, and talked about a few examples.  This time we’ll look at expenses related to financing.

There are two common issues that come up regarding finance-related expenses.  First let’s start with the debt-related one - some assume that our entire loan payments are expenses.  On the other hand, a common mistake is for an entire loan payment to be applied to paying down a loan.  Why is this so confusing?

Loan payments, of course, consist of both principal and interest – some of the payment reduces principal, and the rest of the payment covers the interest that we owe on the loan.  Think about what happens when we borrow the money in the first place - does it increase our profit?  Of course not.  It would be great - well, in the short term, anyway - if we could increase our profits simply by borrowing money, but of course this isn’t the case.  So when we pay back the principal, it also doesn’t decrease our profit - it’s not an expense.  But the interest is an expense - it is the cost that we incur for borrowing the money for this period of time.  So the whole loan payment doesn’t reduce what’s owed - only the principal portion does that, and neither is the whole loan payment an expense - only the portion that pays the interest.

In terms of Equity, we wonder why it’s not an expense when we distribute profits to owners (i.e. pay dividends).  The answer is subtle, but simple.  Dividends are a distribution of profits - they aren’t used to determine the profits themselves.  Profits for a given period are determined by subtracting expenses from revenue, and then those profits are either distributed to owners or they’re kept in the company as Retained Earnings (earnings is another name for profits, so Retained Earnings are simply profits kept in the company instead of being distributed).  So we don’t count dividends as an expense (though we wish we could, because expenses reduce our taxes).

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