Understanding The Expense Account

Running a small business requires more than just focusing on income generation. To ensure those sales translate into profit, you must have a firm grasp on your spending habits. That’s where expense accounts come into play. Let’s break down what they are, why they matter, and how to start.

Key Takeaways – Expense Accounts Explained

• General Ledger: What it is, how to record expenses incurred and double entry bookkeeping.
• Income Statement: Expenses are part of the income statement (Profit & Loss); what is it, and how do you create it?
• Two Main Categories: We will concentrate on the two main expense categories: the cost of goods sold and general and administrative expenses (G&A)

What are expense accounts?

Expense accounts are part of the general ledger that includes every account and transaction. Consider an expense account as a detailed diary of your business’s outgoing funds. It’s where you diligently record every instance of money leaving your business.

Some expenses will reduce the business’s taxable income and, therefore, the tax bill. Please read our guide on claiming business expenses.

Double entry bookkeeping and Expense Accounts

Double-entry bookkeeping is a system where you record every financial transaction in your business twice. Once as a “debit” and once as a “credit”, but both sides must be equal. Debits and credits represent increases or decreases in different parts of your business, like your money, equipment, or expenses.

Why Bother with Expense Accounts?

Expense accounts aren’t just a chore – they offer several key advantages:

Tax time ease: Come tax season, you’ll have all the information you need to claim deductions, ultimately minimising your tax burden.

Effective budgeting: By knowing where your money is going, you can spot areas for cost-cutting or identify where to redirect funds for better growth opportunities.

Financial health checkup: Expense accounts help you stay on top of cash flow and profitability, empowering you to make informed choices for your business.

How to record Expense Accounts

Below are two popular methods of recording business expenses:

Accounting Software

Accounting Software platforms like QuickBooks and Xero offer robust expense management features. You can easily record expenses, categorise them (e.g., rent, supplies, etc.), attach digital receipts, and connect your bank accounts. This automation streamlines the process and provides powerful reporting and budget analysis tools.

Cash Book Template

We have provided a free Excel cash book template to record your income and transactions using a more traditional method. It is designed for ease of use and has a template for Self-employed.

Income Statement (Profit & Loss)

The income statement is one of the main financial statements. It is a picture of your income and expenses during an accounting period. An accounting period might be a month, quarter or a year. The P&L will list the income accounts minus the cost of sales, giving you a gross profit figure. You then deduct the operating costs to leave a net profit or loss.

Types of Expenses Incurred

Expense accounts are split into two main sections: cost of goods sold and operating expenses.

Cost of Sales

Cost of Sales expense accounts are critical in tracking the direct costs associated with creating or acquiring the products you sell. This account includes all the expenses that go directly into producing your goods:

• Raw materials: The cost of the core components or ingredients that make up your products.
• Direct labour: Wages and salaries paid to employees directly involved in manufacturing or assembling your products.
• Manufacturing overhead: Indirect factory costs like rent, utilities, depreciation on equipment, and supplies used in the production process.
• Freight-in: Shipping costs to bring raw materials or finished goods to your business location.

Operating Expenses

Operating Expenses or general and administrative (G&A) expense accounts capture the costs of running the day-to-day operations of your business that aren’t directly tied to producing goods or providing services. Here are some examples:

• Salaries and Benefits: Wages for administrative staff, management, and executives not directly involved in production.
• Rent and Utilities expense account: The costs of office space, electricity, water, internet, etc.
• Office Supplies, postage and Equipment: Everything from pens and paper to stamps and printers.
• Professional Fees: Payments to solicitors, accountants, consultants, and other outside experts.
• Marketing and Advertising: Costs associated with promoting your business and attracting customers.
• Travel and Entertainment: Travel expenses for business purposes and client-related entertainment costs.
• Bank Charges: Charges for bank fees and interest expense.

Depreciation expense account

Depreciation is how you account for the cost of your business’s assets, like computers, machines, and cars, over their life. Instead of taking the total hit in one year, you spread the cost over the time you expect to use the asset.

Recording transactions to the Expense Account

There are several ways to record expenses in the accounting system:

Manual: The traditional way to record an expense to the accounts is to record it manually. This process can cause user input errors, but this is the option of choice for most small businesses.

Automatic Entry: Most accounting software packages allow uploading a bill or using apps like Dext and Auto Entry. By scanning or taking a photo of the bill, the software will extract the details and allow you to review them. This process can save both time and errors.

Expense Account Examples

Below are a couple of expense account transactions and details of where they appear on the Income statement based on the cash accounting system.

The first example is you purchase 500 worth of products for the cost of sales, and you pay with cash.

Explanation:

• Cost of Goods Sold increases (debit) because you have incurred a direct cost for producing your goods.
• Cash decreases (credit) since you used cash to make the payment.

The second example is 1,000 paid in cash for rent expense.

Explanation:

• Rent Expense increases (debit) as you’ve incurred an operating cost.
• Cash decreases (credit) as you pay rent from your bank account.

Below is an example of the income statement showing where expenses appear.