Incurred vs. Accrued in Accounting – Main Differences and Examples
In accounting, incurred refers to when the business owes money as a result of a transaction, while accrued refers to the practice of recording financial transactions as they happen – regardless of any cash exchange. While incurred and accrued mean different things, some may confuse one for the other.
This post will focus on incurred and accrued expenses to better understand the accounting process.
Companies Incur Expenses By Doing Business
Incurring an expense is part of running a business regardless of the industry.
Incurred refers to being liable for a loss or an expense during the accounting period that would lead to actual or potential spending for your company.
Companies need to purchase goods or services to produce a product or perform a service. When your business enters a transaction to procure goods or a service, it owes money to the supplier and therefore incurs an expense.
For instance, a grocery store needs to purchase milk from the manufacturer to sell to its customers. When the grocery store needs to restock and order milk, it incurs an expense whether the order gets paid upon delivery or in net terms. The expenses incurred would then be part of the Cost of Goods or Services sold.
However, a company can incur an expense in other ways.
When Do Companies Incur an Expense?
A business incurs an expense in two instances – upon purchase or when it consumes a resource.
Like the example above, operating expenses like supplies would be on purchase. However, companies also incur an expense due to the passage of time or consumption.
Interest expense is an example of an expense incurred over time. This means that even without a supporting document like a purchase order or an invoice, the company can incur an expense.
Companies Can Incur Expenses and Pay in the Same Reporting Period
As mentioned above, companies incur expenses whether the business paid cash or not. Companies often make cash payments at the point of sale for small items like supplies.
When companies pay for an expense in cash, the company records the transaction as a cash purchase that increases the corresponding expense while decreasing total cash.
For instance, if the business purchases supplies for $1,000, accounting records will show a debit to Office Supply Expense and a credit to the Cash account. As a result, Supplies expense will increase while cash will decrease. However, not all cash payments are for incurred expenses. Companies may pay for expenses in advance like Prepaid Rent and Insurance.
Companies may also incur an expense paid in the next accounting period. Scenarios like this usually happen when the company pays using trade credit or is yet to receive an invoice or bill for an incurred expense. Companies record expenses belonging to the latter category as accrued expenses.
What are Accrued Expenses?
Accrued refers to an expense incurred but not paid in the same reporting period. Accrued expenses are unpaid financial obligations that lack invoice or documentation. These accrued expenses are current liabilities recorded in the balance sheet that the company should pay within the next 12 months.
A company needs to incur expenses first before it records an accrued expense. Accruals are only required when companies do not pay incurred expenses at the end of the period.
Consider this scenario.
Suppose a business incurs rent for May amounting to $5,000, but the actual payment happens on June 5. In that case, the company needs to record the accrued expenses liability, Accrued Rent Expense, by the end of May.
Aside from rent, companies often record accrued expenses for the following:
Accrued Interest
When your company takes out a loan, payment due dates don’t always fall at the end of the period.
For instance, a company borrowed from a bank, and principal and interest payments are due on the 15th of the following month. If the business follows a calendar year and ends on December 31, the next payment will be on January 15. Since the company owes interest from December 16 to 31, it needs to record an accrued expense for interest incurred for 16 days.
Unremitted Taxes
Companies may also record an accrued expense for unpaid taxes.
Tax payment deadlines do not coincide with the end of the reporting period, but companies still have to record tax expenses for the period. For instance, the income tax payment deadline for a calendar year could be on July 31.
By December 31, the company needs to recognize Income Tax Expense and record an accrued liability for Income Tax Payable.
Companies also need to record accrued expenses for employer payroll taxes to cover social security and insurance not remitted at the end of the period.
Unpaid Salaries
Another familiar scenario where companies record accrued expense is when pay periods do not coincide with the accounting period. For instance, the cut-off for calculating monthly payroll is on the 5th and 20th of the month.
For instance, at the end of November 30, the company would have owed employee wages for ten days from 21st to the 20th. As a result, the business needs to report accrued expenses for salaries owed.
Recording Accrued Liabilities is a Must Under Accrual Accounting
When preparing financial statements, companies commonly use two methods – cash basis and accrual basis.
Accrual basis is the gold standard in accounting since it results in a more accurate picture of a company’s financial health.
Companies accrue expenses to satisfy the requirements of the accrual basis of accounting – companies have to record expenses when incurred and revenue when earned rather than when the business receives cash.
As a result, companies record income even if they did not collect cash from customers and expenses, even if they did not receive a billing or an invoice yet.
On the other hand, cash basis accounting is more common for smaller businesses. Under the cash accounting method, companies record income and expenses based on when money changes hands. This method is straightforward since the basis for recording entries depends on cash flow.
Cash Vs. Accrual Accounting Differences and Application
The main difference between cash and accrual accounting lies in the “timing.”
Small businesses prefer a cash basis as they don’t have to pay taxes for unpaid goods or services, which improves cash flow. Meanwhile, the accrual basis is more resource hungry and complicated as accounting teams have to prepare accruals at the end of the period. At the beginning of the next period, they have to reverse some accruals.
Large companies required to follow Generally Accepted Accounting Principles naturally report financial statements using Accrual basis accounting. In the US, GAAP regulations apply to listed companies and those reporting sales revenue of over $25 million for three years. (1)
The International Financial Reporting Standards or IFRS, the prevailing standard-setting body that governs standards for preparing financial information internationally, sets the requirements for preparing financial statements through International Accounting Standards 1. (2) IAS 1 also requires entities to prepare all financial statements except for the Statement of Cash Flows to use the accrual basis of accounting. (3)
Accrued Expense Vs. Accounts Payable
Companies who purchase goods and services using trade credit record the transaction under a current liability account – Accounts Payable. (4)
The Accounts Payable account is different from Accrued Expense Liability as payables are short-term debts. Offering trade credit is so common that about half of businesses in both Eastern (5) and Western Europe offer trade credit to business clients, so it’s common for companies to have Accounts Payable under the current liability section. (6)
Another difference lies with the certainty of the amount. Companies estimate accrued expenses and the actual cash paid could change upon settlement. Meanwhile, companies pay the invoice amount for Accounts Payable and unless there is an error in the invoice, the amount recorded as payable should also be the amount paid to settle the expense.
Why Understanding Key Accounting Terms Matter
Companies today see an urgent need for automating accounting processes to make financial statement preparation faster and less expensive while improving the reliability of financial data. The artificial intelligence market in accounting is already a $1,721.9 million market in 2021, with a forecasted compound annual growth rate of about 45% from 2021 to 2028. (7)
Automation is changing the role of finance teams, and as companies introduce more technologies to improve efficiency, every employee will be part of the accounting process. Today, smart expense management tools like Envoice are already using the information submitted by employees.
With automated checks and verifications set up, transactions that go through AI reviews may end up directly into accounting records integrated with the app. However, companies cannot rely on technology alone – employees should also do their part to ensure the accuracy and reliability of financial data.
Emerging technologies will continue to improve and upgrade, but they will never completely replace the human component. Whether they work with the accounting department or not, employees should understand accounting basics and terms like incurred and accrued to support a shift towards a leaner and more efficient team.
Experience how emerging technology allows companies to increase expense visibility, explore the Envoice app now.
Article sources:
(4) https://www.freshbooks.com
(5) https://group.atradius.com
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