How to Read Financial Reports for Expenses - dummies

By Lita Epstein

Expenses include the items on a financial report that a company must pay for to operate the business that aren’t directly related to the sale and production of specific products. Expenses differ from the cost of goods sold, which can be directly traced to the actual sale of a product. If management doesn’t carefully watch the expenses, the gross profit can quickly turn into a net loss.

Expenses make up the second of the two main parts of the income statement; revenues make up the first part.

Advertising and promotion, administration, and research and development are all examples of expenses. Although many of these expenses impact the ability of a company to sell its products, they aren’t direct costs of the sales process for individual items. The following are details about the key items that fit into the expenses part of the income statement:

  • Advertising and promotion: For many companies, one of the largest expenses is advertising and promotion. Advertising includes TV and radio ads, print ads, and billboard ads. Promotions include product giveaways or name identification on a sports stadium. If a company helps promote a charitable event and has its name on T-shirts as part of the event, it must include these expenses in the Advertising and promotion expense line item.

  • Other selling administration expenses: This category is a catchall for any selling expenses, including salespeople’s and sales managers’ salaries, commissions, bonuses, and other compensation expenses. The costs of sales offices and any expenses related to those offices also fall into this category.

  • Other operating expenses: If a company includes line-item detail in its financial reports, you usually find that detail in the notes to the financial statements. All operating expenses that aren’t directly connected to the sale of products fall into the category of other operating expenses, including these expenses:

    • General office needs: Administrative salaries and expenses for administrative offices, supplies, machinery, and anything else needed to run the general operations of a company are reported in general office needs. Expenses for human resources, management, accounting, and security also fall into this category.

    • Royalties: Any royalties (payments made for the use of property) paid to individuals or other companies fall under this umbrella. Companies most commonly pay royalties for the use of patents or copyrights that another company or individual owns. Companies also pay royalties when they buy the rights to extract natural resources from another person’s property.

    • Research and product development: This line item includes any costs for developing new products. You find details about research and product development in the notes to the financial statements or in the managers’ discussion and analysis. Any company that makes new products has research and development costs because if it isn’t looking for ways to improve products or introduce new products, it will likely lose out to a competitor.

  • Interest expenses: This line item shows expenses paid for interest on long- or short-term debt. You usually find some explanation for the interest expenses in the notes to the financial statements.

  • Interest income: If a company receives interest income for any of its holdings, you see it in this line item. This category includes notes or bonds that the company holds, such as marketable securities, or interest paid by another company to which it loaned short-term cash.

  • Depreciation and amortization expenses: Depreciation on buildings, machinery, or other items, as well as amortization on intangible items, fall into this line item. You have to look in the notes to the financial statements to find more details on depreciation and amortization.

  • Insurance expenses: In addition to insurance expenses for items such as theft, fire, and other losses, companies usually carry life insurance on their top executives and errors and omissions insurance for their top executives and board members. Errors and omissions insurance protects executives and board members from being sued personally for any errors or omissions related to their work for the company or as part of their board responsibilities.

  • Taxes: All corporations have to pay income taxes. In the taxes category, you find the amount the company actually paid in taxes. Many companies and their investors complain that corporate income is taxed twice — once directly as a corporation and a second time on the dividends that the shareholders receive. In reality, many corporations can use so many tax write-offs that their tax bill is zero or near zero.

  • Other expenses: Expenses that don’t fit into one of the earlier line items fall into this category. What goes into this category varies among companies, depending on what each company chooses to show on an individual line item and what it groups in other expenses. However, a firm doesn’t include expenses relating to operating activities in this category; those expenses go on the line item for other operating expenses.