First, consider some clear-cut examples of true expenses. Perhaps the most obvious example is the amount paid for goods that are sold at retail. The long title for this particular expense “merchandise cost of sales.” Thus, if you buy a shirt for $12 dollars and sell it for $20 dollars….you have two amounts to be accounted for: first, the sales revenue for $20 dollars, second, the expense of the shirt for $12 dollars that will be designated as cost of goods sold. One thing to note is that the shirt, as long as it remains unsold on the counter or shelves, are assets except to the extent that they suffer deterioration or obsolescence. Modify this example a little bit by placing an ad in a newspaper for your shirt. The ad cost $5 dollars. We now have a $12 dollar expense of the shirt + a $5 dollar ad as a new expense to be counted against the revenue of $20 dollars. These two expenses are recognized in the period in which the corresponding revenues were produced.
Reflect on this situation for a moment. Accountants are called upon to produce income statements that are intended to show the amount of income earned in the period covered by that particular income statement. In short, net income is the amount of gain produced by the revenues of the period minus the expenses of the period. Expenses of a given period are a kind of cost – amounts given up up to produce the revenues (and resultant net income) of the period. Thus the amount expended to buy, or construct a manufacturing plant and manufacturing equipment is not an expense. But as time passes and these assets are used for the production of goods that are sold for revenues, the plant and equipment depreciate. To the extent that such depreciation ascribable to the manufacture of goods that are sold is an expense. We will look more closely at depreciation tomorrow.
