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    Accounting Standards Library
    Sunday
    Oct102010

    What is the difference between cost and expense?

    The difference between cost and expense is a considerable one, and yet the terms are frequently intermingled. This makes the difference extremely difficult to understand for those people training to be accountants, and who are therefore uncertain about the nature of the terms.

    Cost most closely equates to the term expenditure, so it means that you have expended resources in order to acquire something, transport it to your location, and set it up. However, it does not mean that the acquired item has yet been consumed. Thus, an item for which you have expended resources should be classified as an asset until it has been consumed. Examples of asset classifications into which purchased items are recorded are prepaid expenses,  inventory, and fixed assets.

    For example, the cost of an automobile may be $40,000 (since that is what you paid for it) and the cost of a product you built is $25 (because that is the sum total of the expenditures you made to build it). The cost of the automobile likely includes sales taxes and a delivery charge, while the cost of the product probably includes the cost of materials, labor, and manufacturing overhead. In both cases, you have expended funds to acquire the automobile and the product, but have not yet consumed either one. Accordingly, the first expenditure is classified as a fixed asset, while the second one is classified as inventory. Similarly, an advance paid to an employee is classified as a prepaid expense.

    Expense is a cost whose utility has been used up; it has been consumed. For example, the $40,000 automobile you purchased will eventually be charged to expense through depreciation over a period of several years, and the $25 product will be charged to the cost of goods sold when it is eventually sold. In the first case, converting from an asset to an expense is achieved with a debit to the depreciation expense account and a credit to the accumulated depreciation account (which is a contra account that reduces the fixed asset). In the second case, converting from an asset to an expense is achieved with a debit to the cost of goods sold and a credit to the inventory account. Thus, in both cases, we have converted a cost that was treated as an asset into an expense as the underlying asset was consumed. The automobile asset is being consumed gradually, so we are using depreciation to eventually convert it to expense. The inventory item is consumed during a single sale transaction, so we convert it to expense as soon as the sale occurs.

    Another way of thinking of an expense is any expenditure made to generate revenue under the matching principle, which was particularly apparent in the last case, where inventory was converted into an expense as soon as a sale occurred. Under the matching principle, you recognize both the revenue and expense aspects of a transaction at the same time, so that the net profit or loss associated with the transaction is immediately apparent. Thus, a cost converts to an expense as soon as any related revenue is recognized.

    A key reason why a cost is, in practice,  frequently treated exactly as an expense is that most expenditures are consumed at once, so they immediately convert from a cost to an expense. This situation arises with any expenditure related to a specific period, such as the monthly utility bill, administrative salaries, rent, and so forth.

    Unfortunately, cost and expense tend to be used interchangeably even within the accounting terminology. Even the "cost of goods sold" term just used should really be called "expense of goods sold," since it refers to costs that were charged to expense when a sale of goods was completed.

    The master glossary of the accounting standards codification that is maintained by the Financial Accounting Standards Board does not define either term; consequently, the definitions given above are derived from common usage.

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