New business owners or those new to accounting tend to equate expenses with cash output, with the assumption that any expense created by your business will also include a reduction of cash. While that is true if you’re using cash basis accounting, if you’re using accrual accounting, a recorded expense does not always include a reduction of cash.
For small business owners, depreciation expenses are likely to be the most common type of non-cash expense that your business will need to worry about. Remember that depreciation is used to expense a large-ticket item over its useful life, rather than expensing it at the time of purchase.
Depreciation is considered a non-cash expense since you’re only recording the monthly expense, as the cash outlay was already recorded when the item was originally purchased.
Overview: What are non-cash expenses?
Non-cash expenses, sometimes known as non-cash charges, are any expense recorded in your income statement that does not involve an outlay of cash. Non-cash transactions are always recorded in the income statement, as they directly impact total net income, but do not impact cash flow.
For example, your business purchases a large piece of equipment for your factory. The equipment cost $5,000, which you paid for in cash. However, the expense of the equipment was not recorded at the time of the purchase, but instead will be depreciated over five years. This is how you would record the initial expense, which will affect your cash flow statement:
|11-1-2020||Fixed Assets – Equipment||$5,000|
Next, you’ll need to create a contra account for your equipment to keep track of your monthly depreciation expense. This expense will be recorded each month for the next five years until the equipment has been fully depreciated or disposed of.
If you’re using accounting software, one of the easiest ways to be sure that the depreciation expense is recorded properly is to create a recurring journal entry, which ensures that your income statement will be accurate each month.
Because you’ve already paid for the item in full when it was purchased, you’ll only be recording the item’s expense each month and not its cost.
3 non-cash expenses your business can experience
There are numerous types of non-cash expenses your business may experience, but there are three non-cash charge examples that are most commonly experienced by small businesses.
1. Depreciation expense
Any time you purchase a big-ticket item for your business, it will need to be depreciated. Depreciation, as detailed above, is the act of expensing the purchase over the useful life of the asset rather than expensing it all at one time. Because you’ve already expended the cash but will be expensing the asset over its useful life, the depreciation expense is considered a non-cash expense.
2. Amortization expense
Amortization is similar to depreciation but deals with intangible assets such as patents, copyrights, and other assets that do not have a physical presence but need to be expensed over their useful life. And like a depreciation expense, an amortization expense is considered a non-cash expense, since the asset has already been paid for.
3. Provision for bad debt
If you sell on credit, chances are that some of the customers that purchased products on credit will not pay. While small amounts can be simply written off at year’s end, larger amounts should be expensed during the year to more accurately account for customer payments that may not be paid. This can be done by creating a contra-account that is used with your accounts receivable account.
For example, Katie runs a small gift shop that recently started selling to customers on credit. Previously, her bad debt amount was very small, but now she would like a more effective way to account for any possible bad debt at the end of the year. If Katie’s typical accounts receivable amount was $18,000, she could estimate that around 10% of that may not be received from her customers. To record that expense, she would complete the following journal entry:
|12-1-2020||Bad Debt Expense||$1,800|
|12-1-2020||Allowance for Doubtful Accounts||$1,800|
At the end of the year, when Katie can better determine how much bad debt she needs to write off, she can adjust her allowance for doubtful accounts and her accounts receivable account accordingly. Any bad debt that she expenses for the year will be considered a non-cash expense because the amount is entered to reduce her accounts receivable balance and does not directly affect her cash balance.
Example of a non-cash expense
Maria owns a small publishing company. One of her competitors is going out of business, giving Maria the option to purchase the copyright on several publications. Maria ends up purchasing several copyrights for $10,000 and will be good for the next ten years.
To properly record this purchase, Maria will need to amortize the expense over the next ten years. Her first step would be to record the initial purchase of the intangible asset:
|10-1-2020||Intangible Assets – Copyright||$12,000|
After the initial recording of the purchase, Maria will need to amortize the copyright expense over the next ten years. She would need to create a contra account to record her amortization expense and then make the following entry:
|10-1-2020||Amortization Expense – Copyrights||$100|
|10-1-2020||Accumulated Amortization – Copyrights||$100|
Again, like depreciation, an amortization expense is considered a non-cash expense, since the cash part of the transaction has already been properly recorded.
3 best practices when recording non-cash expenses
To properly record non-cash expenses, you or your bookkeeper need to understand exactly what non-cash expenses are and how they should be recorded. While depreciation and amortization are two of the most common non-cash expenses that small business owners will need to deal with, there are other non-cash expenses that all business owners should be aware of. Following these best practices can help.
1. Remember to record non-cash expenses only on your income statement
Expenses like depreciation and amortization expenses need to be properly recorded on your income statement. This will reduce net income and net taxable income. Keep in mind that non-cash expenses will not have any impact on your cash flow statement, as the cash has already been accounted for at the time of the original purchase.
2. Learn the difference between cash flow and net income
Net cash flow and net income are not the same. Cash flow represents the amount of cash that flows into and out of your business, while net income indicates the amount of money your business has earned after the appropriate revenue and expenses have been taken into consideration.
3. Familiarize yourself with non-cash expenses
While depreciation and amortization are the most common types of non-cash expenses your small business will likely need to deal with, there are several other types of non-cash expenses you should be aware of.
• Stock-based compensation
• Unrealized gains
• Unrealized losses
• Deferred income taxes
• Asset write-downs
• Provisions for future losses
• Asset impairments or charges
While most of the items on this list of non-cash expenses are more likely to impact publicly held businesses, non-cash expenses such as asset write-downs and provisions for future losses can certainly impact small businesses as well as their larger counterparts.
Why do non-cash expenses matter?
Expenses do not always indicate a reduction in cash. Non-cash expenses such as depreciation reduce income but do not impact cash flow. If you’re using accrual accounting for your business, properly recording non-cash expenses is a must for producing accurate financial statements.
It’s also important to remember that non-cash expenses only affect your income statement, where they have a direct impact on taxable income for your business.
The post 3 Non-Cash Expenses Your Business Can Experience appeared first on The blueprint and is written by Mary Girsch-Bock
Original source: The blueprint