Definition of Non-Cash Expenses
Non-cash expenses can be defined as expenses which are charged off as expense which had either been incurred during any of the previous accounting periods or will be incurred in future but does not involve any cash outflow during current accounting year or writing off of any recognized asset under company’s profit and loss account.
Explanation
Non-cash expenses are the cost/ expenses incurred/ charged by the company which does not involve cash outflow during the current accounting period in which it is recognized as an expense. These expenses also form part of the company’s profit and loss A/c but does not affect cash balance. Measurement and recognition of such expense is a result of the accrual concept of accounting and matching principle which states that expenses should be recognized and recorded as and when they are incurred (not when they are paid). Some common examples of non-cash expenses are depreciation, amortization, accrued expenses like tax expenses incurred but not paid as on balance sheet date, etc. Organizations often seek to play down the importance of non-cash expenses significantly one after another in order to adjust earnings to evacuate the impact on financial figures.
How does It Work?
Non-cash expense is a charge against earnings of the company which does not involve cash outflow. An organization incurs non-cash expenses against balance sheet non-cash items. These non-cash items are charged as expenses in the income statement. Like debtors is the money of the business that is owned by the company but has not been received.
It is very important for the companies to record the non-cash expenses, on the other hand, it is also important to note that most of these transactions require estimates. For example, there are various products that require maintenance by the company. Therefore, in order to accompany the maintenance cost, the company sets aside an allowance which is a non-cash item. A higher estimate for the allowance, lower will be the income of the business while a lower estimate can create a problem in the future for meeting future obligations in the case where actual expenditure exceeds planned. Therefore, management needs to be very careful while recording non-cash items.
On one side, non-cash expenses reduce generated profit figure while on the other side, it may also lead to a reduction or lowering of asset balance. For example, writing off debtors will have a negative impact on P&L A/c on one hand and a reduction in the value of debtors from the balance sheet on the other hand. The company may use non-cash expenses as a medium of window-dressing.
Examples of Non-Cash Expenses
Below are some of the examples of non-cash expenses.
1. Depreciation
Depreciation is the most common example of non-cash expenses. It is a method of writing-off the cost of a physical or tangible asset over its useful life and represents how much an asset has been used till now. Charging depreciation helps business to charge off the cost of a relevant asset according to its usage. If it is not taken into the account, it can significantly affect profits. The business charges depreciation on long term assets for both tax and accounting purposes. The internal revenue system states that while depreciating the asset, the cost must be proportioned over its useful life. As long-term assets are expected to generate economic benefits for more than one accounting period, its cost also gets splitted as expense over such useful life period.
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2. Amortization
Amortization is a process of spreading the cost of an intangible asset over its useful life. It is a non-cash expense. The assets which are amortized don’t have any resale value or salvage value. Amortization is similar to depreciation charge but the only difference is that it is charged on intangible assets. Examples of assets that are amortized are franchise contracts, organizational costs, patents and trademarks, cost of issuing bonds.
3. Unrealized Gains and Unrealized Losses
There are always two sides of every situation- one being a positive one and another is the negative one. The market price of an investment as on the balance sheet may be the different date from its initial purchase price. If the market price on the balance sheet date is higher than its purchase price, it’s a situation of unrealized gain. In real terms, there is no cash profit, it is only paperwork until the investment is sold and the position is closed. While on the other hand, the same is for unrealized losses, where the market price of investment falls below its purchase price, it becomes a case of unrealized loss. This difference will get recorded in the company’s books as non-cash expenses (loss) and it’s only on paper and no actual cash loss is involved until investments are sold. As both the unrealized gain and loss are on paper and have no impact on cash flow so these are considered as non- cash expenses.
4. Stock-Based Compensation
According to US GAAP stock-based compensation is classified as non-cash expenses in the income statements. Stock-based compensation is also known as share-based compensation which refers to the method in which employees of the company are rewarded with the equity ownership of the company. Many organizations provide employee stock options and are included in their salary packages. As there exists no actual cash outflow, employees are rewarded with the company’s shares. This is generally preferred when the company is not having enough cash to pay off its employees.
Non-Cash Expenses on Income Statement
In accounting terms, items like depreciation, amortization forms part of financial transactions that are included in the net income of the business but these expenses does not have any impact on working capital i.e. cash flows. Although these transactions do not impact the cash flow of the business but have a significant impact on the bottom line of the income statements i.e.reduces profits reported. The income statement is primarily used by various stakeholders to get an idea of profits generated, analyze, and understand various line items contained in it. Non-cash expenses are the same as other write-downs, which results in the lowering of reported earnings.
Advantages of Non-Cash Expenses
Some of the advantages are:
- As non-cash expenses don not involve cash, they do not affect its working capital requirement.
- Non-cash expenses help in saving tax by deducting expenses from revenue.
- Non-cash expenses facilitate in writing off a tangible and intangible asset over a period of time.
- It helps investors to determine the actual amount of money earned or lost during the year.
Disadvantages of Non-Cash Expenses
Some of the disadvantages are:
- These are only paper expenses and have no connection with the actual flow of cash.
- Non-cash expenses must be adjusted for financial analysis.
- Non-cash expenses reduce the profit of the company.
- Proper estimates are required in order to charge non- cash expenses as they are spread over a period of time.
- These may be used as a means of window dressing by management for over/ under-stating its income.
Conclusion
Non-cash expenses are expenses recorded and recognized in the company’s books of accounts under income statements which are either paid during any previous financial year or accrued expenses which will be paid in the future or arise due to any asset write-off etc. Such expenses reduce amount of profits generated and have a negative impact on its profitability. Since no cash payments are involved during the reported accounting period, it does not affect working capital for that accounting period. Management should analyze and accurately record such non-cash expenses as there exist room for window dressing by under/ over-stating such expenses in the company’s Income Statement.
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