What is a Business Expense?
Every business incurs expenses. In fact, they’re the everyday costs that come with running a company. These expenses are an integral part of the company’s financial statements—particularly the income statement. They provide insight into how much it costs to run the business and where, specifically, management spends money outside of core operations.
Also called deductions, business expenses come with varying tax implications and ramifications for a company’s bottom line. Understanding what constitutes a business expense and how they factor into a company’s financial operations is important. Here’s what you need to know.
CAPEX vs. OPEX
Not all expenses are the same. Business expenses occur in two categories: capital expenditures (CAPEX) and operational expenditures (OPEX).
- CAPEX refers to large expenses that directly affect assets, either for acquisition or upkeep. CAPEX represents reinvestment in the business and is typically a positive expense—especially when a company strategically depreciates the expense.
- OPEX are general business expenses that occur daily, affecting the company’s operations directly. Moreover, they span an incredibly diverse range of purchases and transactions, from travel and insurance to licensing and leasing.
The distinction between CAPEX and OPEX is extremely important due to the tax implications that come with each. For example, a company can depreciate CAPEX over a period of years using either straight-line or accelerated methods. Meanwhile, it records OPEX expenses in a specific time frame with no depreciation.
Deductible vs. Non-Deductible Expenses
Most business expenses are deductible based on the nature of the expense and how it’s recorded on the company’s financial records. Section 162 of the Internal Revenue Code (IRC) offers guidelines for which expenses are ordinary and necessary: qualified deductions. There are, however, some expenses that aren’t deductible.
Here’s a quick breakdown of both deductible and non-deductible expenses and how to identify them.
Deductible Business Expenses
Any expense that’s ordinary and justifiably necessary to a business’ operations can be expensed. This means it’s tax-deductible. Depending on the nature of the expense, it may qualify for full or partial deduction. For example, some of the most common deductible expenses include:
- Advertising and marketing expenses
- Capital systems repair and maintenance costs
- Equipment or property rentals or leasing costs
- Expenses with employee benefit programs
- Insurance and utilities expenses
- Ongoing education and training expenses
- Wages to contract employees
Non-Deductible Business Expenses
Section 162 of the IRC defines several business expenses that do not qualify for deduction in the eyes of the IRS. These expenses aren’t deemed necessary or ordinary, and do not fall under either CAPEX or OPEX classifications. Examples include:
- Fines, penalties and fees
- Political campaign donations
- Lobbying costs
- Any expenses incurred illegally
Business Expenses on the Income Statement
Companies record all expenses on the income statement. Here, these business expenses are subtracted from revenue figures to show the company’s net income. On the balance sheet, business expenses break out into different line items depending on the nature of the expense:
- Direct costs. These are business expenses directly attributable to the cost of producing goods or delivering a service. Specifically, they include direct labor, materials and supplies.
- Indirect costs. Indirect expenses are the costs to keep the business itself running, such as rent, utilities, insurance, office supplies and more.
- Interest expense. This is the cost of borrowing associated with accessing capital. Or, in simpler terms, the interest payments the business makes on loans.
In addition to these three primary categories, many companies also break out their expenses into additional categories when warranted. Examples of additional expense line items include:
- Depreciation. Depreciation expense depends on the asset and whether the company is using a straight-line or accelerated depreciation method.
- Gifts, meals, entertainment. These are the costs associated with doing business, including meeting with potential customers or rewarding/incentivizing employees.
- Reimbursements. These expenses are ones employees have incurred on behalf of the business, that the business then reimburses them for.
The breakdown of business expenses varies slightly from company to company, depending on the industry they’re in and the common types of expenses incurred.
What Investors Can Learn From Business Expenses
Business expenses tell investors how a company spends the money that it earns as revenue. In general, high direct costs tell us that it costs a large sum of money to produce a product or offer a service. Hefty interest expense means that companies are paying a big price to borrow money. This is likely at an unfavorable rate or in excess of what it needs. And as you can see, too many gift expenses could signal reckless spending.
Investors can (and should) probe a company’s income statement to see where it’s racking up expenses. For example, are they one-time? Recurring? Variable? Context is everything when determining if a company is simply going through a growth spurt or if it’s financially mismanaged. Overall, you do not want avoidable expenses piling up.
The Bottom Line
Every business incurs expenses. However, the nature of those expenses is what truly has an impact on the business itself. Whether they’re CAPEX or OPEX, partially or fully deductible, and how they’re recorded on the income statement all matter. Additionally, the nature of the expenses themselves matters to investors evaluating the company.
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Companies with compounding expenses on the income statement need to ask themselves which are necessary vs. extraneous. Investors probing those financials need to ask the same question. Moreover, understand the implications of expenses on the company’s financial prospects. Organizations that can control business expenses and keep them low will find themselves more profitable.