However, it is not always so easy to estimate "indirect" or "overhead" expenses. These costs are especially difficult to estimate when overhead or indirect activities support multiple products or product lines. The Income statement category Operating Expenses typically appears with two main sub-categories:.
In all cases, nevertheless, operating expenses are subtracted from Gross profits to produce the Operating Profit. Note especially that the term Operating margin refers to Operating Profit as a percentage of Net sales. These expenses do not impact Income statement Gross profit because they appear below after the Gross profit line.
For this reason, these expenses are sometimes called "below the line" costs. Operating expenses, however, do impact Operating Profit and bottom line Net profit. Extraordinary expenses and Financial expenses usually appear below Operating Profit on the Income statement.
Only when the firm operates in the financial industry, do financial expenses appear higher on the Income statement. For financial firms, these expenses may rightfully belong under "Cost of Services" or "Operating Expenses. Outside the financial industries, of course, these expenses impact only one profit result, bottom line Net profit. Non-cash expenses are charges against earnings which exist solely to reduce Net profit thereby lowering taxes. They do not represent actual cash flow.
Note that "non-cash expenses" are not an Income statement category. They are instead a kind of expense that can appear in any of the major categories above. Depreciation expense is probably the best known non-cash item on the Income statement.
Others include amortization and writing off of bad debts. Note also that each non-cash expense must also conform to the "expense" definition above:. Income statement depreciation is therefore rightfully called "expense," even though it does not result in cash flow. Depreciation charges, however, bring several other non-cash actions:. E xpenses are center stage in daily operations, budgeting, planning, and preparing the Income statement report.
Exhibit 2 is an example Income statement with significant expense categories including 1 Cost of goods sold, 2 Selling expenses, and 3 Administrative overhead expense. O rganizations track and report spending by recording transactions in Expense category accounts.
Accounts are the fundamental building blocks of the organization's accounting system, and the complete list of named accounts for the system is the organization's "Chart of accounts.
The "Chart of accounts" for organizations that use double-entry accounting includes the following five kinds of accounts:. When the business pays out funds, the appropriate expense account balance changes.
In the language of double-entry bookkeeping, transactions in expense accounts are nearly always debited. And, for these accounts, debits increase the account balance. As the payout increases, the debit balance increases. Every debit to an expense account occurs along with an equal, offsetting credit transaction in another account. With expense transactions, the offsetting credit usually impacts an account in another category, for example, an asset account, or a liability account.
Consider for instance what happens when a firm buys office supplies an expense with cash an asset :. For more on offsetting debit and credit transactions, see Double-Entry System. F irms usually plan, authorize, and manage expense spending through budgets.
Budgets result from a budget process , which repeats every budget cycle. Operating expenses OPEX represent spending for normal business operations. Money collected for gift cards, subscriptions, or as advance deposits from customers could also be liabilities. Essentially, anything a company owes and has yet to pay within a period is considered a liability, such as salaries, utilities, and taxes. Even though the company does not have to pay the bill until June, the company owed money for the usage that occurred in May.
Therefore, the company must record the usage of electricity, as well as the liability to pay the utility bill, in May. Eventually that debt must be repaid by performing the service, fulfilling the subscription, or providing an asset such as merchandise or cash.
Some common examples of liabilities include accounts payable, notes payable, and unearned revenue. Accounts payable recognizes that the company owes money and has not paid. A notes payable is similar to accounts payable in that the company owes money and has not yet paid. Some key differences are that the contract terms are usually longer than one accounting period, interest is included, and there is typically a more formalized contract that dictates the terms of the transaction.
Thus, the account is called unearned revenue. The company owing the product or service creates the liability to the customer.
These two components are contributed capital and retained earnings. The company will issue shares of common stock to represent stockholder ownership. You will learn more about common stock in Corporation Accounting. These retained earnings are what the company holds onto at the end of a period to reinvest in the business, after any distributions to ownership occur. One tricky point to remember is that retained earnings are not classified as assets.
Distribution of earnings to ownership is called a dividend. The dividend could be paid with cash or be a distribution of more company stock to current shareholders. Either way, dividends will decrease retained earnings. Also affecting retained earnings are revenues and expenses, by way of net income or net loss.
Revenues are earnings from the sale of goods and services. An increase in revenues will also contribute toward an increase in retained earnings. Expenses are the cost of resources associated with earning revenues. An increase to expenses will contribute toward a decrease in retained earnings.
Recall that this concept of recognizing expenses associated with revenues is the expense recognition principle. Some examples of expenses include bill payments for utilities, employee salaries, and loan interest expense. For example, you will not recognize utilities as an expense until you have used the utilities. The difference between revenues earned and expenses incurred is called net income loss and can be found on the income statement.
Net income reported on the income statement flows into the statement of retained earnings. If a business has net income earnings for the period, then this will increase its retained earnings for the period. This means that revenues exceeded expenses for the period, thus increasing retained earnings.
If a business has net loss for the period, this decreases retained earnings for the period. This means that the expenses exceeded the revenues for the period, thus decreasing retained earnings. The statement of retained earnings computes the retained earnings balance at the beginning of the period, adds net income or subtracts net loss from the income statement, and subtracts dividends declared, to result in an ending retained earnings balance reported on the balance sheet.
First, however, in Define and Examine the Initial Steps in the Accounting Cycle we look at how the role of identifying and analyzing transactions fits into the continuous process known as the accounting cycle.
The Financial Accounting Standards Board had a policy that allowed companies to reduce their tax liability from share-based compensation deductions. Figure Which of the following does not accurately represent the accounting equation? Figure Which of these statements is false? Figure Which of these accounts is an asset? Figure Which of these accounts is a liability? Figure State the accounting equation, and explain what each part represents.
Figure How do revenues and expenses affect the accounting equation? Figure Does every transaction affect both sides of the accounting equation? Explain your answer. Figure Consider the following accounts, and determine if the account is an asset A , a liability L , or equity E. Figure Provide the missing amounts of the accounting equation for each of the following companies.
The recording rules for revenues and expenses are:. The reasoning behind this rule is that revenues increase retained earnings, and increases in retained earnings are recorded on the right side. Expenses decrease retained earnings, and decreases in retained earnings are recorded on the left side. Remember, any account can have both debits and credits. Here is another summary chart of each account type and the normal balances. Regardless of what elements are present in the business transaction, a journal entry will always have AT least one debit and one credit.
Skip to main content. Chapter 2: The Accounting Cycle. Search for:. General Rules for Debits and Credits One of the first steps in analyzing a business transaction is deciding if the accounts involved increase or decrease. Watch this video to help you remember this concept: Review this quick guide to recording debits and credits.
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