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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!

This entry was posted on Friday, June 26th, 2009 at 7:32 am by Max Minkoff and is filed under Accounting, Tips. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.