Incurred means having become liable or subject to something, and in accounting the something is an obligation. That has a timing consequence. A cost that has been incurred belongs to the period the obligation arose in, whether or not it has been paid and whether or not an invoice has arrived. It is the past tense and past participle of the verb incur.
The general sense is older than accounting and wider than it. Incur comes from Middle English incurren, from Latin incurrere, literally to run into, from in- and currere, to run (Merriam-Webster). What the business runs into is the obligation and not the goods, which is why a firm incurs a cost in the same grammar as it incurs a penalty.
The Word on the Books
On the books the word is not commentary about a cost. It sits inside the definition of an expense. An expense arises two ways under the FASB’s framework, and one of them is the incurrences of its liabilities (FASB Concepts Statement No. 8, Chapter 4, paragraph E81), the other being assets used up. The element itself is set out in expense, and the obligation the verb attaches to is set out in liabilities.
The Word on a Return
On a return the word is a defined term, and what it reaches depends on the taxpayer. The terms paid or incurred and paid or accrued shall be construed according to the method of accounting upon the basis of which the taxable income is computed under subtitle A (26 U.S.C. 7701(a)(25)).
That phrase is how the Code writes the ordinary business deduction, which reaches the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business (26 U.S.C. 162(a)). Because the wording is construed by the taxpayer’s method, that is two limbs and not one idea. A cash-method taxpayer reaches the cost through paid. An accrual-method taxpayer reaches it through incurred, which is the limb that lets a December cost with no December payment be a December deduction.
What the word means and when its test is met are separate questions. The regulation sets out the conditions for a taxpayer using an accrual method (26 CFR 1.461-1(a)(2)(i)), and the all events test and economic performance are both worked through in accrual accounting.
Being incurred settles which year, not what happens in it. Applicable provisions of the Code, the Income Tax Regulations, and other guidance published by the Secretary prescribe the manner in which a liability that has been incurred is taken into account, so section 162 provides that the deductible liability generally is taken into account in the taxable year incurred through a deduction from gross income, and under section 263 or 263A a liability that relates to the creation of an asset having a useful life extending substantially beyond the close of the taxable year is taken into account in the taxable year incurred through capitalization (26 CFR 1.461-1(a)(2)(i)). Same word, same year, two destinations, and which outlays get capitalized rather than deducted is set out in expenditure.
What can be incurred is also wider than what can be deducted. The term liability includes any item allowable as a deduction, cost, or expense for Federal income tax purposes, and in addition to allowable deductions it includes any amount otherwise allowable as a capitalized cost, as a cost taken into account in computing cost of goods sold, as a cost allocable to a long-term contract, or as any other cost or expense (26 CFR 1.446-1(c)(1)(ii)(B)). An amount a taxpayer expends or will expend for capital improvements to property must therefore be incurred before the taxpayer may take it into account in computing its basis in the property (the same paragraph).
Incurred Versus Paid
Paid is about the money leaving. Incurred is about the obligation arriving. For a taxpayer on the cash method the phrase construes to the paid limb (26 U.S.C. 7701(a)(25)), and under that method amounts representing allowable deductions shall, as a general rule, be taken into account for the taxable year in which paid (26 CFR 1.461-1(a)(1)), so the distinction does its work where a period is reported on an accrual basis.
The two can also run in the order nobody expects, and the regulation says so plainly. The term liability is not limited to items for which a legal obligation to pay exists at the time of payment, so amounts prepaid for goods or services, and amounts paid without a legal obligation to do so, may not be taken into account by an accrual basis taxpayer any earlier than the taxable year in which those amounts are incurred (26 CFR 1.446-1(c)(1)(ii)(B)). Money already out of the bank is not, on its own, a cost incurred. Where a payment that ran ahead of the benefit parks in the meantime is set out in deferral.
The other direction leaves a balance too. A cost incurred and not yet invoiced or paid sits as a liability until the cash catches up, and where that lands on an ordinary supplier balance is set out in accounts payable.
Incurred Versus Accrued
On the books, incurred names the event and accrued names what the books did about it. A cost is incurred when the obligation attaches, and it is accrued when someone posts the entry that puts the amount in the period it belongs to, so a cost can be incurred in a month nobody accrued it and the books for that month are simply short. The entry, the balance it leaves and the reversal that clears it are set out in accruals.
On a return the two words do not split that way, because the Code construes paid or accrued exactly as it construes paid or incurred (26 U.S.C. 7701(a)(25)), and under an accrual method a liability is incurred in the taxable year the all events test is met and economic performance has occurred (26 CFR 1.461-1(a)(2)(i)). So for an accrual-method taxpayer an amount is accrued in the year it is incurred whether or not anyone posted an entry.
Common Questions
It means the party has become subject to it, and in ordinary English the thing is usually unwelcome. A person, or something composed of people such as a company, incurs, or becomes subject to, something negative, and what is incurred is usually a self-inflicted consequence such as a debt or somebody’s foul temper (Merriam-Webster). Accounting keeps the mechanics and drops the charge, so a business incurs a liability with no suggestion that anything went wrong.
In finance the verb does the same work on debt that it does on cost. A business incurs debt at the moment it becomes obligated to repay, which is a different moment from drawing the money or starting to pay interest. Credit agreements lean on that difference, because a covenant can be written to apply only when the borrower acts, such as by taking on new debt, rather than in every reporting period, and that split is set out in covenants.
To be the party the obligation lands on. Bearing a cost and paying it are different acts, so a cost can be incurred by one business and settled out of another’s bank account without moving the period, or the books, it belongs to.
It is the act that decides which period each expense belongs to, rather than the act of spending. A firm incurring expenses through a month is accumulating obligations, and each one belongs to the month its obligation arose in even where the invoice turns up later, which is why a close tests the cutoff, meaning which side of the period end each cost fell on. Where that step sits in the sequence is set out in the month-end close checklist.
Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a firm can put a real block of its own period-end cutoff work through a trial task before anything client facing depends on it.
