To arrived at net income or total comprehensive income, expenses are deducted from the gross income. What are the expenses in the field of accounting? This lesson explains everything you need to know.
Definition of expenses
According to the International Financial Reporting Standard (IFRS) conceptual framework, “expenses decrease in assets and increase in liabilities which result in a decrease in equity other than distributions made by holders of equity claim.”
In a general definition, expenses can be defined as the amount incurred to aid an entity in earning income.
Key explanations of expenses
Explanations according to IFRS conceptual framework
Expense are decreased in assets: Assets decrease in value as a result of being used up. There are various ways assets can be used.
Cash, a foremost asset is used up when it is used to pay bills and stock inventories. None current assets deplete during use in the ordinary course of business. Factory plants, for example, reduces in value during usage and therefore depreciated on a yearly basis.
Expenses are increasing in liabilities. When liabilities increases, it increases the cost of paying for such debt. For example, if a firm debt is 3 million Naira this year with an interest rate (cost of debt) of 10 percent per an um, then, it’s yearly interest rate is 300,000 Naira. Therefore, profit will decrease by that amount.
However, if the firm increases the debts to 5 million Naira in the coming year. The interest rate becomes 500,000. This decreases net income (profit) by 200,000 Naira more than the current year. Therefore confirming that an increase in liabilities is expenses.
The resulting effects are a reduction in equity (or capital). How is this so? Profits are added to capital in the statement of financial position. Therefore the increase in expenses will reduce profit thereby resulting in a decrease in equity. In some cases, expenses may be more than gross income. This results in a loss. In this extreme case, capital is reduced.
For example, if a firm’s capital is 4 million Naira and it incurred a net loss for the year for say 700,000 Naira. In the statement of financial position, the 700,000 Naira is subtracted from the equity of 4 million Naira. This reduces the capital to 3.3 million Naia for that year.
Such reduction inequity is not a result of distribution to holders of equity claims. Distributions to the holder of equity, that is, shareholders are dividends. Dividend reduces equity, but according to the IFRS conceptual framework, it is not an expense.
Explanation base the general definition of expenses
Expenses are incurred by a firm. Expenses can be incurred in two ways. Expenses in the ordinary course of business and losses.
Expenses in the ordinary course of business are necessary for the entity to earn revenue. In a trading firm, the purchase of inventories, salaries paid to sales representatives, electricity bills, depreciation of delivery van and loss allowances are examples. This type of expense can be operating expenses or non-operating expenses.
Losses, on the other hand, are incurred when the cost of selling a non-current asset is greater than the disposal value. For example, if a firm decided to sell one of it’s the motor car as scrapped for 350,000 Naira. And the estimated value of the car after deducting depreciation for all its useful life is 370,000 Naira, the firm will sell such a car at a loss of 20,000 Naira.
The expenses are incurred to earn revenue. There is a saying that to make money you must spend money. Expenses are incurred majorly to earn revenue.
In the next article, the definition and explanation of equity will be explored.