Expenses in Accounting Explained for Dummies

What is an expense?

In accounting, an expense is an amount of money that a business is required to spend regularly, to pay for, or buy something in order to generate revenue.

Recording of expenses

Expenses are recorded in expense accounts in the general ledger (GL) of a business by way of debit entries. A corresponding credit entry is recorded, reducing an asset, or increasing a liability. For instance:

• Business A buys R2 000 of stationery. The amount of R2 000 is debited to the expense account ‘Stationery’ and credited to the asset account ‘Cash’, reducing the cash by R2 000.
• Business AA purchases computer software to the amount of R5 000 on credit from a supplier. A debit entry of R3 000 is entered into the expense account ‘Computer expenses’ and the liability account ‘Accounts Payable’ is credited with R3 000, increasing the liability by R3 000.

According to the accrual principle[1] in accounting, expenses are recognised and recorded when they are incurred, not by definition when they are paid for.

Expenses are reflected on the income statement of a business, as deductions from total revenue to determine the net income of the business.

According to the accounting equation[2], expenses effectively reduce the owners’ equity of a company.

Difference between cost and expense

Although two different concepts, the terms cost and expense are frequently intermingled and are used interchangeably. However, each one of them has a distinct meaning in accounting.

Simply put, all expenses are costs, but not all costs are expenses.

Cost is the amount of money that has to be paid or spent in order to obtain an asset. Cost implies a one-time event such as the purchase of an asset.

An expense is a cost that has expired, a cost whose utility has been consumed. Put differently, an expense refers to the consumption of the item acquired.

Contrary to cost, expense is an amount of money that must be spent regularly to pay for something, and ongoing payment, like rent and utilities.

Types of expenses

Expenses can be categorised in different ways and into various types. This article will focus on two ways of categorisation, namely a general and comprehensive categorisation.

General categorisation (Four types)

The most common way of categorising expenses is to categorise them as follows: operating versus non-operating and fixed versus variable.

Operating expenses

Operating expenses are the expenses a business incurs as part of its normal and regular business operations.

Operating expenses comprise, among others, the following expenses:

• Cost of goods sold (COGS) – costs directly involved in the production of goods.
• Salaries and wages.
• Rent.
• Utilities.
• Selling, general, and administrative (SG&A).

(Operating expenses are discussed in more detail under the title ‘Comprehensive categorisation’ in this article.)

Non-operating expenses

When a business incurs expenses unrelated to its core or normal operations, it is called non-operating expenses.

Non-operating expenses include, inter alia, expenses such as:

• Finance charges (Interest).
• Impairment charges (Recorded when the recoverable amount of an asset is lower than the book value).
• Legal fees.

(Non-operating expenses are discussed in more detail under the title ‘Comprehensive categorisation’ in this article.)

Fixed expenses

Fixed expenses refer to expenses that are due on a regular basis, such as weekly or monthly. Basically, they are expenses that do not usually change from payment date to payment date. When fixed expenses do change, it normally happens once a year. For example, when the rent of a property is adjusted.

Furthermore, fixed expenses can be described as expenses that do not fluctuate with changes in production level or sales volume.

The following expenses are examples of fixed expenses:

• Rent.
• Equipment leases.
• Insurance.

Variable expenses

Variable expenses are not constant but fluctuate over time. They are expenses that vary in proportion to volume of goods manufactured or services provided by a business.

Variable expenses increase when the volume of production increases and decrease when the production volume is cut back.

Common examples of variable expenses are:

• Direct labour.
• Direct materials.
• Transaction fees.

Comprehensive categorisation (Six types)

The following comprehensive categorisation identifies six types of expenses, namely: cost of goods sold (COGS), operating expenses (OPEX), non-operating expenses, financial expenses, non-cash expenses, and capital expenses (expenditure) (CAPEX).

Cost of goods sold (COGS)

Cost of goods sold (COGS) refers to expenses incurred by a business with the production and sale of goods (products) as well as with the provision of services. COGS are expenses directly incurred when a transaction occurs.

Generally, the term cost of goods sold (COGS) is used in term of goods and services. Although sometimes the term is exclusively used with regard to manufacturing businesses. When this happens, the term ‘cost of services’ is used regarding service businesses, and when a business sells both goods and services, the term ‘cost of sales’ is used.

Some examples of cost of goods sold are:

• Labour directly involved in the production of goods.
• Direct materials needed for production of products and provision of services.
• Production overheads.

COGS is reported on the income statement of a business and is deducted from revenue (sales) to determine the gross profit of a business.

The basic formula to calculate cost of goods is as follows:

• Amount of inventory at the beginning of a given financial period, such as a financial year. (Inventory refers to the items, component parts, and raw materials a business uses in the production of goods.)
• Plus purchases.
• Plus expenses directly related to production.
• Minus the closing balance of inventory at the end of the financial period.

Operating expenses (OPEX)

Operating expenses (OPEX) are expenses incurred by a business in the execution of day-to-day operations. Operating expenses are also related to the sale of goods and services but are not directly tied to the production of goods and services, as is the case with cost of goods sold.

Put differently, operating expenses are required for the daily, regular and core operations of a business.

OPEX is also a line item on a business’s income statement and is deducted from the gross profit to determine the operating profit of a business.

Examples of operating expenses include:

• Rent (office, shop, factory).
• Salaries (executives, management, and administration).
• Advertising and marketing.
• Accounting fees.
• Office supplies.
• Information technology (IT).
• Insurance.
• Business travel fees.

Non-operating expenses

Non-operating expenses are expenses that are unrelated to the core operations of a business that generate revenue.

Examples of non-operating expenses are:

• Interest payments on loans borrowed from financial institutions such as banks. Interest is the cost of borrowing money. This is the most common non-operating expense. Interest can also be classified as financial expenses.
• Expenses with regard to the relocation of a business.
• Losses incurred on the disposition of assets.
• Expenses involved in currency exchanges.
• Unusual costs or costs incurred for one-time events or transactions in the lifespan of a business, also referred to as extraordinary expenses, such as expenses involved in the bankruptcy or the restructuring of a business, or retrenchment of employees.

Non-operating expenses are recorded after the operating profit on the income statement of a business and are subtracted from the operating profit to calculate the amount of earnings before taxes (EBT).

Financial expenses

Financial expenses are also expenses that are not directly related to the daily operations of a business.

Financial expenses comprise, inter alia:

• Interest payable on long and short-term debt.
• Charges related to loans or mortgages such as origination fees.
• Foreign exchange losses on debt.
• Commissions incurred on the business’s liabilities.
• Charges and impairment losses on investments.

Non-cash expenses

Non-cash expenses are those that do not require any actual cash transaction. They are expenses that reduce earnings (profit) but not the cash flows of a business.

There are many types of non-cash expenses, such as:

• Depreciation, commonly referred to as wear and tear, refers to the reduction in the value of an asset over a certain time frame. It is the most common type of non-cash expenses.
• Amortisation is the process of spreading the repayment of loans, or the cost of intangible assets, over a specific period of time.
• Share-based compensation, also called stock-based-compensation, is a method used by companies to reward employees with shares or share options instead of cash.
• Depletion is a method used in accrual accounting to allocate the extracting costs pertaining to natural resources such as minerals, timber, and crude oil.
• Unrealised gains (profits) or losses, commonly referred to as ‘paper profits’ or ‘paper losses.’

An unrealised profit refers to the increase in the value of an asset that has yet to be sold for cash. The profit only becomes realised when the asset is sold for a profit.

Contrarily, an unrealised loss occurs when a business is holding an asset that has decreased in value but has not yet been sold. The loss is realised when the asset is sold for a loss.

• Deferred income taxes are taxes due by a business to the South African Revenue Service (SARS), but which are not yet due for payment.
• Provisions for future losses refer to funds set aside by a business to cover predicted losses in the future.
• Write-downs of assets are transactions in accounting in which the book value of an asset is reduced to bring it in line with the asset’s current market value.
• Goodwill impairments occur when a company pays more than book value for an asset or set of assets, creating an amount of goodwill. (The difference between the purchase price and the book value of the asset is called goodwill.) When the book value of the goodwill becomes impaired (decreases) the business is required to adjust the value of the goodwill accordingly.

Capital expenses (CAPEX)

Capital expenses, also called capital expenditures, refer to expenses incurred when a business acquires fixed assets, such as property or plant and equipment, to improve the efficiency or capacity of the business. In addition, capital expenses can also be incurred when existing facilities are upgraded or intangible assets, such as patents or trade licences, are acquired.

Put in other words, a capital expense is an expense incurred by a business to create a future benefit, meaning acquiring assets (tangible and intangible) that have a useful life of more than one financial year.

Basically, there are two forms of capital expenditures, namely:

• expenses to maintain present operation levels within the business, and
• expenses that will enable an increase in the future growth of the business.

Noteworthy, payments made with regard to the maintenance and repair of assets are not considered capital expenditure. Such expenses should be recorded in the maintenance and repairs expense accounts in the general ledger of a business.

Tax-deductible business expenses

The South African Revenue Service (SARS) allows South African businesses (sole proprietors and companies) to deduct approved expenses, called tax-deductible expenses, from their net earnings (profit).

The tax-deductible expenses reduce the amount a business is required to pay taxes on. For example, a business’s net profit before tax is R700 000 for the tax year and it incurred tax-deductible expenses of R90 000. Hence, the business’s taxable income would be R610 000 (R700 000 – R90 000).

SARS defines tax-deductible expenses as ‘expenses incurred in the operation of a business.’ Put differently, only expenses that are incurred in the generating of income are considered tax-deductible expenses.

Examples of tax-deductible expenses:

The examples do not encompass a complete list. If you are uncertain about the expenses allowed, contact SARS or a tax consultant.

Expenses in the day-to-day operations

Expenses allowed that are incurred in running a business are, among others:

• Expenses for acquiring raw materials for the production of goods.
• Wholesale purchase costs for goods to be resold.
• Salaries and other employee costs.
• Phone and data expenses.
• Insurance.
• Rent (office, shop, factory).
• Travel and transport (Including expenses pertaining to business vehicles).
• Repairs and maintenance.
• Accounting fees.
• Utilities
• Bank fees.
• Marketing, advertising, and promotion expenses.

Important to know:

• Tax-deductible expenses that have been incurred, but not yet paid for, are allowed.
• Fines and penalties are not tax-deductible expenses and are to be added back to net profit when the taxable income is calculated.

Non-cash expenses

Depreciation, also referred to as ‘wear-and-tear allowances’ by SARS[3], on items (for instance, equipment and vehicles) are deductible, provided that the items are owned by the business and are used in the operations of the business.

Other types of deductible-tax expenses

Entertainment expenses

These are expenses, such as drinks, meals, and live entertainment, incurred while entertaining clients. However, a business must convince SARS that the expenses were incurred in pursuit of business.

Education expenses

Expenses incurred for education of business owner(s) and personnel that directly relate to business operations.

Business start-up expenses

These are expenses related to business operations that were incurred before the first year the business started to operate.

[1] Refer the article, ‘Accrual Accounting Explained for Dummies’, for more information about the accrual principle.

[2] See the article, ‘The Accounting Equation Explained for Dummies,’ for a detailed explanation of the accounting equation.

[3] SARS issued a document, “Binding General Ruling (Income Tax) 7 (Issue 4)”, with the subject, “Wear-and-tear or depreciation allowance” on February 9, 2025. An annexure – “schedule of write-off periods acceptable to SARS”, is available on pages 13 – 20 of the document. The annexure lists more than 50 qualifying assets with their ‘proposed write-off periods’ (in years).