Although the terms ‘expenses’ and ‘assets’ are often used interchangeably in everyday language, they have different meanings and implications in accounting. From a tax and accounting perspective, the terms asset and expense both refer to anything your company purchases in order to do business. However, the similarities end there. Assets and expenses are accounted for differently on your books and have very different impacts on your taxes. Read on to learn more about assets vs. expenses, with some helpful examples to help you understand the differences in how they are treated for tax and accounting purposes.
What is an asset?
- A purchase that a business makes to support its operations
- Typically costs more than $2,500 (although different businesses may set different asset capitalization threshold)
- Most assets are not liquid (cannot be quickly converted to cash without affecting operations)
- The purchase must maintain its worth for at least one year after acquisition
- May either depreciate or grow in value
When accounting for assets, the full cost of the asset is not written off in one year. An asset is expected to last multiple years, so financial professionals create schedules to deduct the depreciation of assets over multiple tax years. Depreciating the cost involves deducting the cost of the item over the number of years the IRS estimates to be the lifespan of the equipment. Because they are used for business purposes, claiming depreciation of these assets helps to reduce the taxable income of the business.
Why use depreciation?
Let’s say you have a business making and selling clothes. You purchase a sewing machine for $3,500. The sewing machine enables you to create the clothing you sell, thus adding value to your business. The sewing machine will last you 10 years before it will need to be replaced by a newer model. If you recorded the sewing machine as a regular expense, the initial $3,500 would only be recorded in the year in which it was bought, which means that your accounts would not reflect the value the machine adds throughout the remaining nine years of its intended lifespan. However, by depreciating the asset throughout its useful life (over 10 years), you’re able to allocate the cost according to the amount of value it adds to your business, thus providing a more accurate picture of what your business is actually worth in a given year.
What is an expense?
- A purchase that a business makes to support its operations
- Typically costs less than $2,500 (depending on the business)
- Does not maintain its worth for more than a year
- Usually consumed immediately by the business
- Deducted right away rather than listed on a depreciation schedule
Expenses directly reduce profit but also decrease tax liability. They will be written off either when the item is paid for (cash-based method of accounting), or when the expense is incurred (accrual method of accounting). If you cannot demonstrate a link between a cost and future revenues, the costs must be expensed immediately. Expenses also offer a great tax-saving opportunity, with the majority being fully deductible business expenses.
For a comprehensive guide to small business tax deductions, download our free guide here.
Examples of assets and expenses
The easiest way to distinguish between an expense and an asset is to look at the purchase price of the item. As outlined in the definitions above, anything that costs more than $2,500 (or whatever your business’ cap is) is generally considered an asset; whereas items under the $2,500 threshold are considered expenses. That said, there can be exceptions.
Examples of common business expenses can include:
- Rent
- Travel
- Utilities
- Office supplies
- Materials
- Insurance
- Salaries
- Entertainment
An example of an asset that likely does not depreciate in value may be land or property. Assets that are likely to depreciate in value include:
- Tools
- Machinery
- Vehicles
- Computer systems
For example, a business purchases a new machine to add to their manufacturing plant with a cost of $4,000. The company estimates its useful life is five years and that it will generate, on average, $1,000 per year in sales. So, rather than including the $4,000 expense on its books in the year that the machine was purchased; it spreads out the asset cost over time according to a depreciation schedule. Because the machine is expected to last for five years, the company will most likely deduct 1/5th of its value each year for the next five years.
There are always exceptions, and depreciation can be accelerated where recommended by your CPA. In the same year, the company purchases a new coffee machine for the office for $300. Using this lower dollar threshold, a company’s fixed asset or depreciable asset register would likely be filled quickly and would require greater administrative effort to oversee and maintain. Therefore to ease the accounting burden, a company may establish an internal capitalization policy whereby it will consider only items that have a cost greater than $2,500 as potential depreciable assets. Under this scenario, the $300 coffee machine is considered an expense (even though it likely has many years of useful life), so the purchase price will be deducted in the same year that the purchase was made.
Your turn—asset or expense?
You run a warehouse for an online retailer. With rapid advancements in technological capability, you’re constantly looking for ways to improve your inventory management and logistics. Through intensive R&D, your team has come up with an innovative new process for warehouse inventory management, which you have now patented as your intellectual property (IP). You paid $50,000 for a patent that allows you exclusive rights over the intellectual property for 30 years.
Are your patent costs an asset or expense?
Tricky one! Patents have associated costs that are capitalized as assets on the balance sheet and amortized over the useful life of the asset. Why? First, with attorney and registration fees, patent costs are typically well over $2,500. Secondly, a patent is intended to offer long-term business value to keep the competition at bay. This competitive advantage increases the value of the company, so must be recorded appropriately.
Here’s another question: Do patents depreciate over time?
No, because a patent is an intangible asset, it is expensed over its projected life or tax or accounting purposes. In this example, your company’s accounting department will post a $1,666 amortization expense each year for 30 years.
We know we threw you a bit of a curveball at the end, but we hope that you found these examples of assets and expenses useful! When in doubt, don’t hesitate to reach out to a qualified CPA for further assistance with all your business accounting questions.