Confusing expenses with disbursements can have negative implications for your business. Learn the fundamental differences between expenses and disbursements.
On the surface, disbursements may look like expenses. Technically, though, they are not a business expenditure. For the receiving party, they can be easily conflated with regular business income. They are not that either.
Treating disbursements as income or expenses can harm your business in several ways. One of these is a tax evasion charge by the Kenya Revenue Authority.
This article will explain the differences between expenses and disbursements so you know how to properly account for them.
What are expenses in business?
Expenses are the things you pay money for in return for goods and services. It is the money you spend money to obtain something. In accounting terms, we can define expenses as the costs you incur to generate revenue.
Since you deduct expenses from your revenue to arrive at the net income, lowering your expenses will increase your profits. However, you have to spend to make money, which means there are expenses you cannot avoid, a typical example of which is rent. Some expenses will rise with production, for example, electricity and raw materials.
Types of business expenses.
Business expenses fall into four main categories, namely:
- Fixed expenses, which do not change with increases in production, like rent and the interest you pay on your business loan.
- Variable expenses; which are those that increase and decrease with production. For example, utilities.
- Operating expenses, which are expenditures that are directly tied to normal business operations. Examples of these are rent, marketing, equipment repairs, and payroll.
- Non-operating expenses; those expenditures not directly incurred in the day-to-day operation of the business, like interest on loans, fines, lawsuit settlements, and losses from equipment depreciation.
What is a disbursement?
A disbursement is money you pay from a dedicated fund, typically on behalf of a third party.
There are two ways of looking at disbursements. The first is that they are distributions of money from a fund to its intended beneficiary. For example, the PAYE remittance you pay to the Kenya Revenue Authority.
PAYE remittances are not a business expense for you. It’s money you are collecting from your employees on behalf of the KRA. In other words, you are acting as an agent of the KRA.
You don’t benefit from a VAT or PAYE remittance; you collect these on behalf of the KRA. Since you are not the entity paying the money, it becomes a disbursement or a distribution.
Another way to look at disbursements is as money you pay out on behalf of another and for which you expect to be reimbursed in full. This can even be money you pay on behalf of your customer.
An example of the above is when a digital marketing agency developing a website for a customer pays the customer’s web hosting expense. This is an expense for the customer, not the marketing agency. The agency must treat it as a disbursement because they expect the customer to pay the money back.
Expenses vs disbursements: What is the difference between them?
The difference between expenses and disbursements is that the former is money you spend to produce goods and services, while the latter is money you pay out on behalf of a third party that is not directly tied to the production and supply of your goods and services.
Both expenses and disbursements are cash outflows or money flowing out of your business, but that’s where their similarities end.
If you must pay money to acquire something that you need to produce the product or service you supply, treat it as an expense. Treat a cash outflow as a disbursement if you are not deducting it from your revenue, or a third party must reimburse you.
For example, if you cover a cost on behalf of a customer, that should not be treated as your expense. It is a disbursement for which you will not put a markup. The customer will reimburse you in the exact amount. Expenses are payments for things like rent and marketing that are necessary for your business.
Disbursements are cash distributions and expenses you cover on behalf of others because it simplifies and speeds up work.
Your employees could pay their own PAYE obligations to the KRA, but it is straightforward and more practical for you to deduct it from their salaries and remit the funds in bulk to the tax authority.
In our example of the web hosting expenses a digital marketing agency pays on behalf of a customer, the customer could perform that task, but it would take more time.
The agency can accomplish this task faster because they are more familiar with the processes and have pre-existing relationships with web hosting providers they can exploit to lower costs for their customers. In this instance, the agency is acting as an agent of its client.
Why you shouldn’t confuse expenses with disbursements.
It is essential to properly categorise expenses and disbursements because the former directly affects your business’s bottom line, and the latter does not.
More critically, expenses are subject to tax, while disbursements are not. To illustrate with an example, you should not add VAT on expenses you cover on behalf of customers when you recharge them. As a result, you also can’t claim back VAT on them.
For example, if you rent out property, the KRA cannot claim tax on the money you accept as tenant deposits because you will pay it back at the end of the tenancy.
On the other hand, you can reclaim VAT on expenses you incur in the ordinary course of business. The main idea is to prevent double taxation.
VAT reclaims are, however, only for bonafide business expenses, in which case they are meant to increase profits and encourage investment.
The implication for misclassifying disbursements as expenses is that you may reclaim VAT where you shouldn’t. Conversely, you may be guilty of prejudicing the KRA if you treat sales as disbursements, meaning you fail to charge VAT assuming they are disbursements exempt from VAT.
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