Expenses and Financing
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!