Expense Account Definition
An expense account is used in accounting to track and categorize the various expenses incurred by a business during a specific period, such as a month, quarter, or year. It helps businesses monitor their spending and analyze where their money is allocated and spent.
Expense accounts play a crucial role in financial reporting. They provide the necessary information to prepare financial statements, such as income or profit & loss statements. These statements summarize the revenue earned and the expenses incurred during a specific period, helping businesses compute their operational cost and assess their financial performance.
Table of contents
- An expense account is a financial record that tracks and categorizes the costs or expenditures incurred by a business in its day-to-day operations. It represents the outflow of resources or the incurrence of expenses necessary to run and maintain the business.
- It helps analyze and track spending patterns, evaluate the company’s financial performance, and make informed cost management and budgeting decisions.
- They are essential for ensuring compliance with tax regulations and other financial reporting requirements. Accurate and detailed expense records are necessary to file tax returns and claim deductions.
How Does An Expense Account Work?
An expense account records and tracks the various expenses incurred by a business. The process of recording expenses starts with classifying the expenditure and setting up accounts for recording them. This organization and analysis lead to better and more effective financial reporting.
Here’s how it typically works:
- Classification and setup: Each type of expense is assigned to a specific expense account. Common examples include office supplies, rent, utilities, travel, marketing, salaries, etc. These accounts are set up in the business’s chart of accounts.
- Recording expenses: When a business incurs an expense, it is recorded in the appropriate expense account. It is typically done through journal entries in the accounting system. The entry debits the expense account, increasing its balance, and credits another account, such as cash or accounts payable, depending on how the expense is paid.
- Organization and analysis: As expenses are recorded in their respective accounts, the balances of the expense accounts accumulate. The expenses within each account can be further organized and analyzed based on their subcategories or periods. For example, within the “office supplies” expense account, expenses for paper, pens, and ink cartridges can be separately tracked.
- Financial reporting: At the end of an accounting period (e.g., monthly, quarterly, or annually), the balances of the expense accounts are summarized in the income or Profit & Loss (P/L) statement. This statement provides an overview of the revenues earned and expenses incurred during the period, resulting in net income or loss calculation.
- Periodic reset: Expense accounts are considered temporary because their balances are reset at the start of each new accounting period. As part of the closing process, the balances of expense accounts are closed and transferred to a permanent account, such as retained earnings or equity accounts, to start afresh from the next accounting period.
Let us look at some examples to understand the concept better.
Here’s a hypothetical example of an expense account called “Advertising Expenses” with a table to illustrate the recording of expenses:
Expense Account: Advertising Expenses
|Online Ads Campaign
|Print Media Promotion
|Social Media Marketing
In this example, the “Advertising Expenses” account tracks the various advertising expenditures incurred by the company in May 2023. Each expense is recorded as a debit entry in the account, increasing its balance.
At the end of the month, the total expenses recorded in the “Advertising Expenses” account will be calculated by summing up the debit column.
Total Advertising Expenses: $25,000
This total amount can then be used to generate financial reports, analyze the company’s advertising costs, and evaluate the effectiveness of its advertising strategies.
This is just a hypothetical example. The actual expenses and amounts recorded by a business vary based on its specific circumstances and practices in the real world.
Here is another example of an expense account maintained by a small retail business:
Expense Account: Cost of Goods Sold (COGS)
|Purchase of inventory
|Returns and allowances
|Cost of manufacturing
The Cost of Goods Sold (COGS) computation tracks the expenses directly associated with producing or procuring goods for sale. It includes the cost of purchasing inventory, freight charges incurred while transporting goods, returns and allowances, and adjustments made to the inventory value.
In May 2023, the retail business incurred various expenses related to COGS. The expenses were recorded as debit entries in the COGS account, increasing its balance. The credit entries represent returns, allowances, and adjustments that decrease the COGS account balance. At the end of the month, total expenses recorded in the COGS account were calculated by summing up the debit column. This amount represents the cost incurred by the business to acquire or produce the goods sold during the month.
This example demonstrates how the COGS account tracks and reports direct expenses incurred for the sale of goods in a retail business.
How To Close?
To close an expense account, companies finalize the expenses incurred during an accounting period and prepare the account for the subsequent period. During the end of the accounting period, the company prepares a closing journal entry. This entry transfers the expense account balance to a temporary account called “Income Summary” or “Profit & Loss Summary”. Debiting the expense account for its current balance reduces the balance to zero.
Simultaneously, the Income Summary account is credited for the same amount, effectively transferring the total expenses from the expense account. Subsequently, another journal entry is created to close the Income Summary account. The Income Summary account is debited for its balance, representing the total expenses transferred from the expense account.
A credit entry is made in the appropriated retained earnings or equity account to reflect the net income or loss. With these steps completed, the expense account is reset to zero, allowing it to restart recording in the next accounting period. Companies must consult professional accountants or follow specific accounting guidelines to ensure accurate and compliant expense account closing procedures.
Frequently Asked Questions (FAQs)
When an expense account is debited, an expense transaction or an expense increase is recorded in the account. Debiting this account results in an increase in the account’s balance. It reflects the additional amount spent or the expense incurred by the business.
While expense and liability accounts are important components of a business’s financial records, they serve different purposes. Expense accounts track a business’s costs, while liability accounts represent the company’s obligations to external parties.
The main difference between expense and revenue accounts lies in their nature and impact on financial statements. Expense accounts track the costs incurred by the business and reduce the net income, while revenue accounts record the income generated by the business and increase the net income. Both types of accounts are temporary and contribute to the calculation of net income on the income statement.
This has been a guide to Expense Account and its definition. Here, we explain in detail with its examples and how to close it. You can learn more about it from the following articles –