The Difference Between Incurred and Accrued Expenses

The timing difference between when a business benefits from a good or service and when it pays for it is a key concept in accounting. Understanding how and when expenses are formally recognized directly influences the reported profitability of a business for a specific period, such as a month or a quarter. These principles ensure that financial statements provide a consistent and comparable picture of business activities.

Understanding Incurred Expenses

An expense is considered “incurred” at the moment a business receives a good or benefits from a service, establishing an obligation to pay. This event is the trigger for recognizing the expense and is separate from the act of payment. For instance, when a shipment of office supplies arrives, the expense is incurred, even if the invoice allows for payment in 30 days. A business also incurs an electricity expense as power is consumed, not when the bill arrives the following month.

This practice is based on the matching principle, which requires that expenses be recorded in the same accounting period as the revenues they helped to generate. By recognizing an expense when it is incurred, a business accurately matches its costs against its earnings for that period. This prevents a distorted view of profitability that would occur if expenses were only recorded when cash changed hands.

For example, if an employee works for a week, the wage expense is incurred daily as the labor is provided to the company. The company has received the benefit of that work and has an obligation to pay for it, regardless of whether payday is tomorrow or next week. Recognizing this expense as it happens aligns the cost of labor with the revenue generated during that same week.

Defining Accrued Expenses

An accrued expense is a specific category of incurred expense. It represents an expense that a business has incurred but has not yet paid or formally recorded through a transaction like receiving an invoice. These are often expenses that accumulate over time, such as interest on a loan or wages. Recording these items is an adjustment at the end of an accounting period to ensure financial statements are accurate under the accrual basis of accounting.

The accrual basis of accounting requires that transactions are recorded when they occur, not necessarily when cash is exchanged. To comply, businesses make adjusting journal entries for accrued expenses. This entry involves debiting an expense account and crediting a liability account. This liability, often titled “Accrued Liabilities,” appears on the balance sheet and represents the company’s obligation to make a future cash payment.

Consider employee salaries at the end of a month. If the month ends on a Thursday but the weekly payroll is not processed until Friday, the company has incurred two days of wage expense that fall within the current month. An adjusting entry is made to debit Wage Expense and credit Wages Payable for those two days. This action ensures the expense is recognized in the period it was incurred, even though payment will happen in the next accounting period.

Similarly, if a company has a business loan, interest on that loan builds up daily. Even if the loan payment is only due on the 15th of each month, at the end of any given month, an amount of interest has been incurred but not yet paid. An adjusting entry is required to record this interest expense and the corresponding interest payable, reflecting the company’s financial obligations.

Practical Application and Financial Statement Impact

Consider a company whose monthly accounting period ends on Wednesday, March 31st. The company’s weekly payroll cycle runs from Monday to Sunday, with employees being paid every Friday for the previous week’s work. The employees who worked Monday, Tuesday, and Wednesday of that final week of March have earned their wages, and the company has benefited from their labor in March.

The wage expense for those three days has been incurred in March. Following the matching principle, the cost of that labor must be matched against the revenues generated in March. Waiting until payroll is processed in April would incorrectly shift a March expense into the next accounting period, understating March’s expenses and overstating its profit.

To prevent this distortion, the company’s accountant will make an adjusting entry to accrue the wages for those three days. An entry is recorded that debits Wage Expense and credits a liability account like Wages Payable for the estimated amount of wages earned. This entry is made before the financial statements for March are finalized.

This action impacts both the income statement and the balance sheet. The amount of the accrued wages appears on the March income statement as part of the total wage expense, reducing the company’s reported net income. The same amount appears on the March 31st balance sheet as a current liability, showing the company has a short-term obligation to pay its employees. When the full payroll is processed in April, the liability is cleared from the books.