What Does It Mean to Incur an Expense?

“Incurring an expense” is a fundamental concept in business and finance that often causes confusion because it differs from simply paying for something. It represents the point at which a business recognizes an obligation or consumes a resource, which is a significant event for tracking financial health. Understanding this distinction is important for anyone trying to interpret how businesses manage and report their financial activities.

Understanding What “Incur” Means

To “incur” an expense means that a business has become obligated to pay for a good or service, or has used up an asset, regardless of when the actual payment occurs. It signifies the economic event has taken place, creating a present responsibility. For example, a business incurs a utility expense the moment it uses electricity or water, even if the bill arrives weeks later. Similarly, employee wages are incurred as employees work, long before payday. This concept focuses on the commitment or usage, not the cash changing hands.

The Accrual Basis of Accounting

The concept of incurring an expense is central to accrual basis accounting, standard for most U.S. businesses and required for public companies under Generally Accepted Accounting Principles (GAAP). Accrual accounting recognizes revenues when earned and expenses when incurred, providing a more accurate picture of a company’s financial performance. This method follows the matching principle, requiring expenses to be recognized in the same period as the revenues they helped generate. For instance, if a company sells a product on credit in December, the cost of that product is recognized as an expense in December, even if the customer pays in January. This ensures costs associated with generating revenue are matched in the same reporting period, regardless of cash flow.

Accrual accounting contrasts with cash basis accounting, recording transactions only when cash is received or paid. While some small businesses may use the cash method, accrual accounting provides a more complete and accurate representation of financial health. Under accrual accounting, common expenses like rent, salaries, and utilities are recorded when the benefit is received or the obligation arises, not when payment is made. For example, a company incurs a rent expense for the month of July on July 1st, even if the payment is due later in the month or was paid in advance.

The Difference Between Incurring and Paying

The distinction between incurring an expense and paying an expense lies in the timing of the economic event versus the cash transaction. Incurring an expense means the obligation has been created or the resource consumed. Paying an expense, conversely, refers to the cash outflow to settle that obligation. There is often a time lag between these two actions.

For example, when a business purchases office supplies on credit, the expense is incurred at the time the supplies are received and used, creating an immediate obligation. However, payment for those supplies might not occur until the invoice due date, perhaps 30 days later. Similarly, a company might prepay for an annual insurance policy, making payment upfront, but the insurance expense is only incurred gradually over the 12-month period as the coverage is used. This separation ensures financial records reflect when economic activities happen, not just when money moves.

How Incurred Expenses Affect Financial Statements

Incurred expenses have a direct impact on a company’s financial statements, particularly the Income Statement and the Balance Sheet. On the Income Statement, incurred expenses are recognized in the period they occur, reducing the company’s net income for that period. This reflects the costs associated with generating revenue, even if cash hasn’t been disbursed. For example, if a business incurs $5,000 in utility expenses for a month, that amount will be recorded on the income statement as an expense.

When an expense is incurred but not yet paid, it also creates a liability on the Balance Sheet. These liabilities are often categorized as “accrued expenses” or “accounts payable,” representing amounts owed for goods or services already received. Accrued liabilities are current liabilities, due within a 12-month period. For instance, wages earned by employees but not yet paid at the end of an accounting period become an accrued liability. The Cash Flow Statement, however, is affected when the payment occurs, not when incurred, highlighting the difference between profitability and liquidity.