A business needs to work well to make money. When a business operates, it spends money on different things like supplies or services. Sometimes, it doesn’t pay for these right away, kind of like using a credit card. When keeping track of money, we count these expenses when they occur, not when someone pays for them. We refer to these expenses as incurred expenses or costs incurred.
Meaning of Incurred Expenses:
When we talk about “incurred expenses,” we mean the expenses a company has to pay for when it uses something or faces a loss. These costs are recorded for the time they were used up or occurred. Costs incurred cover different types of expenses, like direct ones, which are clear-cut, and indirect ones, which are more general. They can include expenses related to production and running the business. This concept also considers expenses from earlier times.
The idea of costs or expenses incurred follows a rule in accounting called accrual accounting. It means we record expenses when they happen, not necessarily when we pay for them. So, even if you haven’t received the bill yet, you still record the expense when you use up what you paid for.
An expense that’s already paid means the bill is settled. To get what “incurred expenses “means, let’s take an example. Imagine you receive raw materials worth SGD 5,000 delivered to your factory. You receive a bill for them, but you haven’t paid yet. Then, you use these materials to make your products. Here, the SGD 5,000 represents the cost incurred. When you finally pay the bill, it becomes a paid expense.
Now, let’s discuss how we keep track of these costs. Since incurred costs are company expenses, we record them in the income statement.
Types of Incurred Expenses
There are different types of incurred expenses. Let’s have a look at the points below.
1. Manufacturing Expense
Manufacturing costs are the expenses associated with turning raw materials into finished products. They cover the cost of materials, the wages of workers directly involved, and any other direct expenses. We note these costs in the trading account.
2. Indirect Expense
Any expense that doesn’t directly relate to making goods or providing services is designated an indirect cost. These costs are for keeping the business running smoothly and can cover operating, administration, selling, distribution, and marketing expenses.
3. Fixed Expense
Fixed costs are expenses in running a business that stay the same for a while and don’t depend on how much stuff is made. Regularly paid costs covering items such as salaries and rent are included in this category.
4. Variable Expense
Variable costs are the expenses for selling the finished product. These costs vary depending on the amount of stuff made.
5. Capital Expense
A capital cost refers to any expense incurred when purchasing significant and essential items for your business. For instance, investing in manufacturing equipment constitutes a capital cost.
Examples of Incurred Expenses
Below, we discuss examples of incurred expenses.
Rental:
Rentals are the fees for using your office or factory area. Despite payment usually occurring later, businesses consider the expense to occur at the start of the month. This means they record it as a cost when the month begins, not when the payment is actually made.
Depreciation
Depreciation means an asset becomes less valuable over time. Even though it’s not actual money spent, you still need to count it as an expense. This is because it represents a cost that occurs over time. So, businesses record it as an incurred cost.
Telephone Bill
Any money spent on telephone bills counts as incurred expenses. It doesn’t matter if you pay it later; it’s still considered a cost that occurred. Therefore, you should record it as an expense in the Profit and Loss statement.
Supplies
Buying raw materials to make goods and services is an expense that is incurred. Once you use up these materials, you should note them as a liability on the Balance Sheet. This action should occur as soon as they are used.
Salaries
Salaries paid to employees and workers represent an incurred cost. Record these expenses by debiting the accrued salaries account.
Let’s take an example of incurred expenses.
Example:
- The machinery depreciates by SGD 10,000, spread evenly over 12 months until December 2022.
- The rent expense for November 2022 totals SGD 5,000.
- The company incurs a fixed cost for salaries. Even though you’ll pay the salary in December, the work done by employees will already be done in November. Therefore, your company should count the cost of SGD 200,000 as part of the expenses for November 2022.
- Telephone and internet bills represent fixed expenses for running the office. Even though you only pay them by the 15th, you still need to account for SGD 200 at the beginning of the month.
- Raw materials are a direct expense for the company. Even though you bought raw materials worth SGD 24,000, only two-thirds of them have been used. So, your company will count only two-thirds of the raw material cost for November 2022 as an expense. That’s SGD 16,000.
Therefore, here are the total expenses your company incurred for November 2022:
Incurred costs = 10,000 + 5,000 + 200,000 + 200 + 16,000 = SGD 231,200
Analysis
Incurred costs show how much money a company owes each month. This number is crucial for accountants to see how the company is doing financially. Understanding these costs helps see where the company spends its money and find ways to improve.
Accountants can plan how to pay these expenses each month. If a company spends more than it earns, managers need to figure out why and find ways to spend less. Keeping an eye on these expenses helps the company make more profit.
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The Usage of Incurred Expenses
Incurred costs are only recorded in accrual-based accounting, which is different from cash-based accounting. In accrual accounting, companies record expenses when they occur, not when they’re paid. For example, if a company incurs a rent expense of SGD 5,000 in November but pays in December, accrual accounting records it in November, while cash-based accounting records it in December.
Accrual accounting recognizes expenses when they occur and necessitates documentation during the reporting period. This helps estimate the company’s profits and losses accurately for that period.
Accrual accounting is good because it accurately shows the company’s financial position over a given time. However, one drawback is that it can show a profit even before the company receives cash. This means it might look profitable even if the company doesn’t have much cash on hand.
Characteristics of Incurred Expenses:
Here are the characteristics of incurred expenses:
Timing of Recognition:
We note down incurred expenses when we utilize the things we paid for, such as materials or services, not when we actually make the payment. This helps match up expenses with the revenue they helped generate, showing a clearer picture of what we’re spending and earning.
Accrual Basis:
In accrual accounting, expenses are noted when they occur, not when we pay for them. This helps give a better idea of how the business is doing financially over a certain time, even if the cash hasn’t been paid yet.
Expense Recognition:
The income statement recognizes incurred expenses and displays a company’s revenues and expenses during a specific period. This allows stakeholders to assess the business’s profitability and make informed decisions.
FAQ’s
What do incurred expenses entail?
Companies record incurred expenses when they use or consume goods or services, regardless of when they make the payment.
What is the difference between accrual and cash-based accounting regarding incurred expenses?
Accrual accounting recognizes expenses when entities incur them, while cash-based accounting records expenses when there is a change in cash.
What makes incurred expenses important for businesses?
Incurred expenses help businesses understand their spending patterns, assess their financial health, and make informed decisions about managing costs and improving profitability.
What are some examples of incurred expenses?
Examples include rent, depreciation, telephone bills, salaries, and raw materials purchased for production.
