Cost Versus Expense
I checked the Cambridge
English Dictionary to find out the definitions of the terms 'cost' and 'expense'.
As per the dictionary, cost means the amount of money
needed to buy, do, or make something, whereas expense means something that
makes you spend money, or the use of money, time, or effort.
In general terms, I understand that cost is the numerical
value of something you want to buy or build (a value), whereas an expense is
often thought of as the actual spending done to buy or build something (an activity).
However, in accounting, this physical act of spending cash is technically an expenditure
(a cash outflow), not necessarily an expense. This is how I perceive the
general, everyday meaning of these two terms. Let’s see how IFRS interprets
these words from a strict accrual
accounting point of view.
Cost from IFRS Perspective
The following are a few accounting standards where cost is
explicitly discussed by IFRS.
IAS 2 – Inventories: The cost of inventories shall
comprise all costs of purchase, costs of conversion, and other costs incurred
in bringing the inventories to their present location and condition.
Cost of inventories =
- Costs
of purchase
- Costs
of conversion
- Other
costs
For example, Person A runs a retail tech shop and want to
build gaming PCs to
sell to its customers. He / She estimates the total cost per unit to assemble, including
the motherboard, RAM, and graphics
card will be $10,000. Since $10,000 exceeds A’s target budget, he/she looks
for better supplier rates and visit Luca Game Store, purchasing all the
necessary components for $7,500. Therefore, the actual historical cost of inventory
is $7,500. As per IAS 2, this $7,500 sits on the statement of financial position
as an asset until A sell’s the PC, at which point it becomes an expense (Cost of Goods Sold).
Let’s have a quick glance at two other standards covering
the definition of cost or related information:
IAS
16 – Property, Plant and Equipment and IAS
38 – Intangible Assets: Cost is the amount of cash or cash equivalents paid
or the fair value of the other consideration given to acquire an asset at the
time of its acquisition or construction or, where applicable, the amount
attributed to that asset when initially recognised in accordance with the
specific requirements of other IFRSs, e.g., IFRS
2 Share-based Payment.
These definitions are very much in line with what I
explained above.
One might question why IAS 16 and IAS 38 share the same
definition of cost, while IAS 2 does not. Part of this is the underlying
purpose: inventory is primarily bought for sale, whereas PPE or intangible
assets are acquired for consumption or use within the business. However, the
structural reason lies in how the standards are drafted. IAS 16 and IAS 38
define 'Cost' strictly as a measurement basis (the consideration given at
acquisition). IAS 2, on the other hand, does not actually define the standalone
word 'Cost'; rather, it prescribes what the 'Cost of inventories' comprises
(the accumulation of purchase, conversion, and other costs).
Expense from IFRS Perspective
Expense: As per the current IFRS
Conceptual Framework, expenses are decreases in assets, or increases in
liabilities, that result in decreases in equity, other than those relating to
distributions to holders of equity claims.
Reading this reminds me of the basic accounting equation I
learnt when I first started studying accounting
: Equity = Assets – Liabilities. You can rearrange this equation using
basic maths.
Let’s assume I purchase a business car worth $100,000. What
happens in the accounting world? Bank <Credit> and
Business Car <Debit>.
The net impact on equity on the very first day is nil (because this is merely
an expenditure, exchanging one asset for another). But after one day, week, a
month, or a year, there will be a decrease in my equity due to depreciation of
the asset. There will be recording of depreciation
expense in my accounting records. I hope the above definition from the
Conceptual Framework now makes perfect sense.
Before I proceed further, the question comes to my mind is, ‘why
is 'cost' not defined in the Conceptual Framework?’
Let’s look at a set of financial statements, specifically
the income statement and the statement of financial position. The broader
categories are Income, Expenses, Assets, Liabilities, and Equity. The word
'cost' does not explicitly appear as a primary category; rather, it is embedded
within these components. The Conceptual Framework, upon which all accounting
standards are based, was designed for the preparation of financial statements. (Historical
cost is mentioned in the Conceptual Framework, but purely as a basis of
measurement, which aligns perfectly with the explanation above.)
Conclusion
Ultimately, while "cost" and "expense"
are often used interchangeably in everyday conversation, IFRS draws a clear,
accrual-based distinction between them. Cost represents the measurement of
resources sacrificed to acquire or build an asset sitting unexpired on the
balance sheet. In contrast, an expense reflects the consumption of that asset
or economic benefit over time, which directly reduces a business's equity.
Understanding this difference is essential for getting to grips with financial
statement mechanics and the true application of IFRS.
Written and Researched by Aamir Sheikh
amr.