What Counts as a Cost, and When

You spend the money. Isn’t that the expense?

This is what students get wrong most often, and the reasoning behind it is reasonable. You are out the money. You feel like you have been economically damaged, so that is when it should be recognized.

What you have to think about instead is when that thing has been used up for the value of the business.

Say you are running a cupcake shop and you buy a pile of raw materials and flour, and you only use half of it. Even though you spent all the money now, you still have half the flour to use next month. If you recognize the whole cost now when you have not used it, you have broken the connection between consuming something to benefit the business and recognizing the expense of it. Next month, when you use it, is the right time - because that is when the thing you spent money on is used to generate the revenue associated with it.

What an expense actually is

An expense is the cost of doing business to earn revenue. The day-to-day cost of running the business: paying for ingredients, wages, rent, utilities.

If you rent a food truck, you have expenses. The cost of all the materials, the bread, the vegetables, the wages you pay people to make sandwiches. All of those are expenses.

So when do we recognize them?

Expenses are recognized when they are incurred - when the goods or services are used. Not necessarily when we pay for them. If a food truck buys vegetables on credit in July but pays for them in August, the expense is recognized in July, because July is when we used it up. That is when we incurred it.

And then the matching principle does the rest. It ensures expenses are recorded in the same period as the revenues they help generate. The food truck sold sandwiches in July, so the cost of those vegetables should be recognized in July, because that is when they were used.

Once you have revenue and expenses, you have enough for the profit equation, which is as simple as it looks.

\[\text{Revenue} - \text{Expenses} = \text{Profits}\]

A business that brings in $10,000 in sales against $7,000 in expenses makes $3,000. Simple subtraction.

What is not an expense at all

Before the timing questions, there is a prior one: does this cost belong to the business?

Take a bakery in July. It spends $2,000 on ingredients - those are expenses, incurred for the bread sold in July. It spends $1,500 on rent, also an expense, because you had to have the location in order to do business. It pays wages to the people making the baked goods, an expense.

Now say the owner throws a dinner party and spends $700. That is not an expense. It was a separate private thing that had nothing to do with the business. We do not throw parties in order to run the business. Same with a vacation unrelated to the business - we are using up funds, but not for the sake of the business, so it is not a business expense.

Put both ideas together and you can work a full month. In September, the bakery purchases $4,000 in ingredients and uses only $3,000 worth. It generates $12,000 in revenue. It spends $2,000 in wages and $1,500 in rent, plus $700 on the owner’s dinner party and $400 on a friend’s birthday gift.

Start with revenue: $12,000. That is easy.

Now expenses. Wages and rent are straightforward, $2,000 and $1,500. For the ingredients we only used $3,000 of the $4,000, so $1,000 stays on the shelf for next month. That gives total expenses of $6,500. The dinner party and the birthday gift are personal and do not enter at all.

\[\$12{,}000 - \$6{,}500 = \$5{,}500\]

That is the profit, once we exclude the personal costs unrelated to the business.

When you pay before you use it

Expenses get complex when the timing of payment does not line up with the period where the expense belongs.

A prepaid expense is any payment made in advance for goods or services you will receive or use later. Insurance is the big one. Imagine the bakery pays $1,200 on July 1 for a one-year policy.

Recognize the whole $1,200 in July and the financials distort. July looks like terrible performance - all these expenses - and then nothing afterward, so every later month looks better than it is. On $10,000 of revenue, July would show $8,800 of profit, and the next eleven months would show no insurance expense at all.

That is not what is happening. You are using up the insurance continuously across the year. So recognize $100 a month, which is what matching recommends.

Now July shows $9,900 and so does August, and so does every month after.

The distortion matters because you need that insurance to do business in all those subsequent months. If the expense is not there, it is sitting in some other month, and you get a mismatch against what is actually happening economically.

When you use it before you pay

Deferred expenses run the other direction: the cost is incurred now, you use it up now, and the payment is not made until later. We recognize expenses when incurred, not when paid.

The same bakery consumes $2,400 of electricity over six months but is not billed until December. You use the electricity, they measure it, they bill you later.

Recognize all $2,400 in December and December looks terrible while every month leading up to it looks good. On $10,000 of monthly revenue, December shows $7,600 and the five months before it show a clean $10,000 each, as though there were no electricity expense at all.

But you used electricity every month. You used $400 of it every single month, and that is what should be recognized in each of the six months, rather than landing all at once in December because December is when you paid.

When you use it for years

As a business grows it invests in long-term assets - equipment, the things that help the business run. Depreciation is how accountants spread the cost of an asset over its useful life, recognizing the gradual use of it over time and aligning the expense with the revenue it generates.

The bakery buys a $12,000 oven in January and expects it to last five years.

\[\frac{\$12{,}000}{5 \text{ years} \times 12 \text{ months}} = \$200 \text{ per month}\]

So on $10,000 of monthly revenue, the depreciation expense is $200, and the profit follows from there. We spread the cost of the asset across all the periods we are using it.

It would be distorted to take the full hit up front. In that first month you would have $10,000 of revenue against a $12,000 oven, which is a $2,000 loss. Every month afterward would look amazing, because there is no cost left - you took it all in the first period.

That is not right, because in all those subsequent months you needed the oven to earn those revenues. It is a violation of the matching principle. For assets that last a long time and do not get used up immediately, we take the cost and spread it over that period, matching the expense against the revenue through depreciation.

Bringing it back

Prepaid expenses, deferred expenses, depreciation. All of it does the same job: putting expenses where they belong so they can be matched against revenue, so the financial statements give an accurate picture.

Here is why that should matter to you personally. Imagine you are going to buy a business.

If the seller grabbed the right periods - took expenses and moved them into a different period, tucked them away outside the window you are looking at - the financials in front of you could look really good. You might say, this is a great business, it is really profitable, I want to buy this. And you would be wrong. Not because anything was left unreported, but because it was stuck in another month and you were shown the others.

Timing matters in accounting statements. That is why we have the matching principle, and revenue recognition rules, and expense recognition rules.

© 2026 Eric Lin. All rights reserved. This chapter is provided for students in BUSI 170 - please do not repost or redistribute without permission.