Session 4

Expenses and
Introduction to Income
Statement
Expense

Businesses incur various types of expenses. An expense is a type of expenditure that flows
through the income statement and is deducted from revenue to arrive at net income. Due to
the accrual principle in accounting, expenses are recognised when they are incurred, not
necessarily when they are paid for.

Expenses Prepaid Accrued

expenses expenses
Income Statement

Expenses

Source: Apple Inc. Form 10K-

Fiscal Year Ended Sep 25, Y1
Expenditure

Expenditure

Capital Expenditure Revenue Expenses

Operating Expenses

Non-operating Expenses
Expenses vs Capital Expenditures

Expenses Capital Expenditures

Revenue expenditures are the ongoing Capital expenditures are typically one-time
operating expenses, which are short-term large purchases of fixed assets that will be
expenses used to run the daily business used for revenue generation over a longer
operations. period.

Recorded through Income Statement Recorded through Balance Sheet

Expensed in the year in which it is incurred Amortized over the life of the asset and
depreciation expense recorded

Cost of goods sold, Salary Expense, Audit Fees Property, Plant & Equipment
etc.
 Expenses - Operating expenses

An operating expense is an expense a business incurs through its normal business operations.
Following are the examples of Operating expenses:

Cost of goods sold

Marketing, advertising

Salary & wages

Selling, general and administrative

Depreciation/ amortisation

Rent / Insurance
Expense - Non-operating expense

Non-operating expenses are other business expenses incurrent by an entity that are unrelated to
the core business operations. Some of the examples of non-operating expenses are:

Interest expenses

Impairment losses

Loss on sale of assets

Multiple Choice Question

A company's financial records for the year show the following expenses:
• Salaries: $150,000
• Rent: $30,000
• Utilities: $10,000
• Advertising Expenses: $20,000
• Interest Expense: $8,000

What is the total amount of operating expenses for the year?

A) $160,000
B) $190,000
C) $210,000
D) $160,000
Multiple Choice Question

A company's financial records for the year show the following expenses:
• Salaries: $150,000
• Rent: $30,000
• Utilities: $10,000
• Advertising Expenses: $20,000
• Interest Expense: $8,000

What is the total amount of operating expenses for the year?

A) $160,000
B) $190,000
C) $210,000
D) $160,000

Answer: C) $210,000
Capital expenditure

Capital expenditure is the investment of capital that a company makes in purchase of long term
fixed assets which has useful life for more than one year. Company can exploit these fixed assets
to generate the revenue. They are also called as CAPEX.

Recognition of Capital Expenditures:

For Example: Purchase of machinery having life of 5 years for $50000

Year 1 Year 1 Year 2 Year 3 Year 4 Year 5

Purchase of machinery $50000
(Life 5 years)
$10000 $10000 $10000 $10000 $10000

Balance Sheet Amortized as Depreciation in Income Statement

Basic Journal Entry: Recording a capital expenditure

Case:

XYZ Purchases Fixed Asset of $450,000

Accounts Involved Type of Accounts Rule Dr Cr

Questions:

Which account to debit?

Which account to credit?
What is the type of account? (Asset/Liability/Revenue/Expenditure)
Whether to Increase or decrease?
Basic Journal Entry: Recording a capital expenditure

Ans.:

XYZ Purchases Fixed Asset of $450,000

Accounts Involved Type of Accounts Rule Dr Cr

Fixed Asset Asset Increasing $450,000
Cash Asset Decreasing $450,000
 Revenue Expenses

Revenue expenditures are short-term expenses used in the current period or typically within one
year. Revenue expenditures include the expenses required to meet the ongoing operational costs of
running a business, and thus are essentially the same as operating expenses (OPEX).

Product Period
Cost Cost
 Product cost

Product costs are costs that are incurred by a business to either acquire or manufacture a product
that is intended for sale to customers. Product costs include direct material (DM), direct labor (DL),
and manufacturing overhead (MOH). Some examples are given below. These expenses are recorded in
the Income Statement as Cost of Goods Sold (COGS) when the sale of the inventory is made (matching
principle).

•Direct material: The cost of wood used to create the tables.

•Direct labor: The cost of wages and benefits for the carpenters to create the tables.
•Manufacturing overhead (indirect material): The cost of nails used to hold the tables together.
•Manufacturing overhead (indirect labor): The cost of wages and benefits for the security guards to
overlook the manufacturing facility
•Manufacturing overhead (other): The cost of factory utilities.
 Period cost

Period costs refer to costs that are not tied to or related to the production of inventory. Period
costs are costs that cannot be capitalized on a company’s balance sheet and are therefore expensed
in the period incurred and appear on the income statement. Period costs are also called period
expenses.

In short, all costs that are not involved in the production of a product (product costs) are period
costs.

Examples include selling, general and administrative (SG&A) expenses, marketing expenses, CEO
salary, and rent expense relating to a corporate office.
Period Costs vs. Product Costs

All costs incurred by a company are either period costs or product costs. Additionally, the two
types of costs are recorded differently. See the table below for more comparison:

Product costs Period costs

Definition: Costs related to the Costs not related to the
production of a product production of a product
Method of Capitalized on the balance Expensed on the income
Recording: sheet as inventory and statement in the period
eventually expensed to cost incurred
of goods sold on the income
statement
Examples: Direct labor, direct Marketing expense,
materials, and selling, general and
manufacturing overhead administrative expense,
and CEO salary
Basic Journal Entry: Payment of salary

Case:

XYZ paid Salary of $67,000 its employees

Accounts Involved Type of Accounts Rule Dr Cr

Questions:

Which account to debit?

Which account to credit?
What is the type of account? (Asset/Liability/Revenue/Expenditure)
Whether to Increase or decrease?
Basic Journal Entry: Payment of salary

Ans.:

XYZ paid salary of $67,000 to its employees.

Accounts Involved
Type of Accounts
Rule Accounts Involved Type of Accounts Rule Dr Cr
Dr Salary Expense Increasing $67,000
Cr Cash Asset Decreasing $67,000
Prepaid expenses

A prepaid expense is an expenditure paid for in one accounting period, but for which
the underlying asset will not be consumed until a future period. When the asset is
eventually consumed, it is charged to expense. If consumed over multiple periods,
there may be a series of corresponding charges to expense.

Year of Consumption
Year of Payment
of service

Cash XX Balance
XX Expense XX
b/f

Balance XX Balance 0
Basic Journal Entry: Advance rent paid

Case:

ABC Inc. paid an advance of $12,000 for a one year rental of a building on Dec 31 Y1. The
building is to be occupied from the following year.

Accounts Involved Type of Accounts Rule Dr Cr

Questions:

Which account to debit?

Which account to credit?
What is the type of account? (Asset/Liability/Revenue/Expenditure)
Whether to Increase or decrease?
Basic Journal Entry: Advance rent paid

Ans.:

ABC Inc. paid an advance of $12,000 for a one year rental of a building on Dec 31 Y1. The
building is to be occupied from the following year.

Accounts Involved Type of Accounts Rule Dr Cr

Prepaid Rent Asset Increasing $12,000
Cash Asset Decreasing $12,000
 Prepaid Expense: T Accounts

Expense & Prepaid Expense

T Accounts Year Y1
Balance Sheet as at 31/12/Y1
Prepaid Rent
Current Asset:
Prepaid Expense 12000
(12000) Cash 12000
Cash

Balance 12000

Cash

Prepaid 12000
Expense

Balance 12000
Basic Journal Entry: Recognition of expense

Case:

ABC occupies the building on January 1 Y2 and stays in the building for one month

Accounts Involved Type of Accounts Rule Dr Cr

Questions:

Which account to debit?

Which account to credit?
What is the type of account? (Asset/Liability/Revenue/Expenditure)
Whether to Increase or decrease?
Basic Journal Entry: Recognition of expense

Ans.:

ABC occupies the building on January 1 Y2 and stays in the building for one month

Accounts Involved Type of Accounts Rule Dr Cr

Rent Expense Expense Increase 1,000
Prepaid Rent Asset Decrease 1,000

Questions:

Which account to debit?

Which account to credit?
What is the type of account? (Asset/Liability/Revenue/Expenditure)
Whether to Increase or decrease?
 Prepaid Expenses: T Accounts

Prepaid Rent and Rent Expense

T Accounts Year Y2
Balance Sheet as at 31/01/Y2
Prepaid Rent
Current Assets:
Prepaid Expense 11000 Balance Rent
12000 1000
b/f Expense

Balance 11000

Income Statement for the period

01/01/Y2 to 31/01/Y2 Rent Expense
Expense: Prepaid 1000
Rent Expense 1000 Expense
Transfer to
Income 1000
Statement
Accrued expenses

An accrued expense, also known as accrued liabilities, is an accounting term that refers
to an expense that is recognized on the books before it has been paid. The expense is
incurred, however the payment for the same has not yet been made. This is a liability
for the entity. Typical accrued expenses include utility, salaries, and goods and
services consumed but not yet billed.

Year of Accrual Year of Payment

Expense XX Balance XX
Cash/Accounts b/f
Payable XX
Balance XX Balance 0
Basic Journal Entry: Accrued Expense incurred

Case:

Salary of $65,000 is outstanding

Accounts Involved Type of Accounts Rule Dr Cr

Questions:

Which account to debit?

Which account to credit?
What is the type of account? (Asset/Liability/Revenue/Expenditure)
Whether to Increase or decrease?
Basic Journal Entry: Accrued Expense incurred

Case:

Salary of $65,000 is outstanding

Accounts Involved Type of Accounts Rule Dr Cr

Salary Expense Increasing $65,000
Outstanding Salary Liability Increasing $65,000
 Accrued Expenses: T Accounts

Expense & Accrued Expense

T Accounts Year Y1
Balance Sheet as at 31/12/Y1
Outstanding Salary
Current liability:
Accrued Expense 65000
Salary 65000

Balance 65000

Income Statement for the year

ended 31/12/Y1 Salary Expense
Expense: Accrued 65000
Salary 65000 Expense
Transfer to
Income 65000
Statement
Basic Journal Entry: Cash paid towards an accrued expense

Case:

Payment of outstanding salary of $65,000

Accounts Involved Type of Accounts Rule Dr Cr

Questions:

Which account to debit?

Which account to credit?
What is the type of account? (Asset/Liability/Revenue/Expenditure)
Whether to Increase or decrease?
Basic Journal Entry: Cash paid towards an accrued expense

Case:

Payment of outstanding salary of $65,000

Accounts Involved Type of Accounts Rule Dr Cr

Outstanding Salary Liability Decreasing $65,000
Cash Asset Decreasing $65,000
 Accrued Expense: T Accounts

Cash and Accrued Expense

T Accounts Year Y2
Balance Sheet as at 31/12/Y2
Salary Outstanding
Current Assets:
Cash Balance
(65000) Cash 65000 65000
b/f

Current Liabilities:
Accrued Expense 0 Balance 0

Cash
Accrued 65000
Expense

Balance 65000
Multiple Choice Question

A company prepaid $36,000 for a two-year insurance policy on July 1. As of December 31

of the same year, what would be the adjusting entry to account for the portion of
insurance expense that has been incurred during that period?
A) Debit Prepaid Insurance $9,000, Credit Insurance Expense $9,000
B) Debit Insurance Expense $9,000, Credit Prepaid Insurance $9,000
C) Debit Prepaid Insurance $18,000, Credit Insurance Expense $18,000
D) Debit Insurance Expense $18,000, Credit Prepaid Insurance $18,000
Multiple Choice Question

A company prepaid $36,000 for a two-year insurance policy on July 1. As of December 31

of the same year, what would be the adjusting entry to account for the portion of
insurance expense that has been incurred during that period?
A) Debit Prepaid Insurance $9,000, Credit Insurance Expense $9,000
B) Debit Insurance Expense $9,000, Credit Prepaid Insurance $9,000
C) Debit Prepaid Insurance $18,000, Credit Insurance Expense $18,000
D) Debit Insurance Expense $18,000, Credit Prepaid Insurance $18,000

Answer: B) Debit Insurance Expense $9,000, Credit Prepaid Insurance $9,000

 Multiple Choice Question

A company's accounting period ends on December 31. As of that date, the

company has incurred $8,000 in rent expense for the month of December,
which will be paid to the landlord in January. What is the adjusting entry to
account for this accrued rent?
A) Debit Rent Expense $8,000, Credit Cash $8,000
B) Debit Cash $8,000, Credit Rent Expense $8,000
C) Debit Rent Payable $8,000, Credit Rent Expense $8,000
D) Debit Rent Expense $8,000, Credit Rent Payable $8,000
Multiple Choice Question

A company's accounting period ends on December 31. As of that date, the

company has incurred $8,000 in rent expense for the month of December,
which will be paid to the landlord in January. What is the adjusting entry to
account for this accrued rent?
A) Debit Rent Expense $8,000, Credit Cash $8,000
B) Debit Cash $8,000, Credit Rent Expense $8,000
C) Debit Rent Payable $8,000, Credit Rent Expense $8,000
D) Debit Rent Expense $8,000, Credit Rent Payable $8,000

Answer: D) Debit Rent Expense $8,000, Credit Rent Payable $8,000

Format of an Income Statement
Income Statement

Source: Apple Inc. Form 10K-

Fiscal Year Ended Sep 25, Y1