An Expense Is What Type of Account in Accounting?

Businesses engage in countless financial activities daily. Accounting systems categorize these transactions into different types of accounts. This systematic arrangement provides a clear picture of a company’s financial health, allowing for accurate record-keeping and informed decision-making. Proper categorization ensures that every dollar entering or leaving a business is tracked and understood.

What is an Expense Account?

An expense account represents the costs a business incurs to generate revenue. These are the outflows of economic benefits that occur as a result of a company’s day-to-day operations. Unlike assets, which provide future economic benefits, or liabilities, which are obligations, expenses are “used up” costs. They reflect the consumption of goods or services in the process of earning income.

Expenses directly reduce a business’s profit, and ultimately, they decrease the owner’s equity or retained earnings. Accurately tracking these costs through expense accounts is essential for understanding profitability and ensuring financial statements reflect the true performance of the business.

How Expense Accounts Function

Expense accounts operate with a “normal balance” that is a debit. This means that when a business incurs an expense, the expense account is increased through a debit entry. Conversely, a credit entry would decrease an expense account, perhaps due to a refund or adjustment.

The increase in an expense account, through a debit, ultimately reduces owner’s equity. This happens because expenses decrease net income, and net income is a component of retained earnings, which is part of owner’s equity. Expense accounts are considered temporary accounts, meaning their balances are reset to zero at the end of each accounting period, typically a month, quarter, or year. This reset is achieved through “closing entries,” where the balances are transferred to an Income Summary account.

The Income Summary account acts as a temporary holding place for all revenue and expense balances for the period. After all temporary accounts are closed to it, the net balance of the Income Summary (representing net income or loss) is then transferred to the Retained Earnings account, a permanent equity account. This process ensures that each new accounting period begins with a fresh set of expense figures.

Examples and Classification of Expenses

Businesses incur a wide variety of expenses in their operations. Common examples include rent for office space, utility bills for electricity and internet, salaries and wages paid to employees, office supplies, advertising and marketing costs, and travel expenses. These are all necessary costs to keep a business running and to generate revenue.

Expenses are often classified to provide more specific insights into a company’s financial activities. A primary distinction is made between operating expenses and non-operating expenses. Operating expenses are the costs directly related to a business’s core activities, such as the cost of goods sold, rent, utilities, and employee wages.

Non-operating expenses, conversely, are costs incurred outside of a business’s normal activities. Examples include interest expense on loans or losses from the sale of assets. While these expenses still impact a company’s net income, they are separated from operating expenses to allow stakeholders to assess the efficiency of the core business operations more clearly.

Impact on Financial Statements

Expense accounts are prominently featured on a company’s Income Statement, also known as the Profit and Loss (P&L) Statement. This financial statement reports a company’s revenues and expenses over a specific period, typically a month, quarter, or year. On the Income Statement, expenses are systematically deducted from revenues to arrive at the net income or loss for that period.

A key accounting principle governing the recognition of expenses on the Income Statement is the “matching principle.” This principle requires that expenses be recognized in the same accounting period as the revenues they helped generate. For instance, if a company earns revenue from a sale in December, the expenses directly associated with that sale, such as the cost of the goods sold, should also be recorded in December, even if payment occurs later.

While expenses directly appear on the Income Statement, they indirectly affect the Balance Sheet. Expenses reduce net income, and this reduction in net income subsequently decreases retained earnings, which is a component of owner’s equity on the Balance Sheet. Depending on how an expense is paid or accrued, it can also affect other Balance Sheet accounts; for example, if paid in cash, the cash asset decreases, or if accrued but unpaid, a liability like accounts payable increases.