When a government entity, such as a state or local government, issues a purchase order or signs a contract, it creates an obligation to pay in the future. The term “encumbrance” reflects the financial commitment to these future expenditures, ensuring that funds are set aside for specific purposes, even though the actual cash outflow has not yet occurred. Encumbrance accounting is a critical tool for managing commitments and ensuring budgetary control. By reserving funds for future obligations, it enhances transparency, prevents overspending, and aligns financial management with organizational goals. The purpose of implementing encumbrances is to enhance budgetary control and prevent overspending.

BAR CPA Practice Questions: Proprietary Funds Statement of Revenues, Expenses and Fund Balances

Each type of encumbrance is meant to protect parties and specify exactly what each claim entails. It is important for buyers of real estate to be aware of any encumbrances on a property since these will often transfer to them along with ownership of the property. Because you’ll be purchasing the equipment in the next quarter, you’ll want to set aside or encumber the funds needed to prevent them from being spent elsewhere. This guide explains everything you need to know—from the meaning of encumbrances to how they work in real-world accounting systems. An accrual, on the other hand, is an expense that has been incurred but not yet paid, such as goods that have encumbrance accounting been received but are awaiting payment. However, the amount is recorded as an encumbrance immediately, reserving that $50,000 for the upcoming expense.

Example Journal Entry

Encumbrances actually aren’t classified as assets or as liabilities on the balance sheet. While it is most commonly applied in government, educational, and nonprofit institutions, it can be a helpful system to employ in any organization looking to tighten up spending. This mitigates the risk of insufficient funds and also enables organisations to take advantage of opportunities by having resources readily available. Encumbrance accounting has three main phases, in line with those for procuring goods or services. Enter your email below to begin the process of setting up a meeting with one of our product specialists.

Why Encumbrance Accounting is Used

This ensures that these funds are earmarked for their intended purpose only, preventing them from being allocated elsewhere. PurchaseControl gives visibility of committed spend and makes encumbrance accounting easier. Encumbrance accounting should not be confused with the term encumbrance in real estate. A property becomes encumbered once it has a Bookkeeping vs. Accounting lien on it, or when there are zoning restrictions.

Many state and local governments are experiencing revenue shortfalls and are facing difficult decisions in balancing their budgets. One option some governments have is to use a portion of fund balance to offset revenue declines and balance the current-year budget. However, not all amounts reported as part of fund balance are available to be assets = liabilities + equity used in a future budget. If a purchase order is canceled, the original encumbrance must be fully reversed to release the funds back into the budget. This process removes the encumbrance and restores the budgetary fund balance, making those funds available for other purposes.

• Note that General Ledger carries forward balances, not as period activity, but as beginning balances.
• This foresight enables timely adjustments to the budget, such as reallocating funds to where they are needed most.
• Any encumbrance funds are not part of the actual funds ledger balance, because payments haven’t been processed.
• Encumbrances should be monitored regularly to ensure accurate tracking of financial commitments.
• For instance, if a city government issues a purchase order for new office supplies, that amount becomes an encumbrance, setting aside those funds.
• Understanding the impact of these reserved funds is essential for stakeholders ranging from finance professionals to policymakers.

• In government accounting, for instance, encumbrances are leveled against the relevant appropriation account and are often used when there are multi-year contracts in place.
• This transparency promotes accountability, as leaders are held fully responsible for managing resources efficiently.
• This error may also result in incorrect fund balances, as expenditures reduce fund balances while encumbrances only reserve funds within the budget.
• You specify an encumbrance type when you enter an encumbrance and when you perform inquiries.
• This practice helps organizations track their outstanding commitments and ensures accountability for how public or donor funds are allocated.
• Requisition encumbrances are automatically relieved when requisitions become purchase orders.

We also allow you to process your invoices and payments your way, whether that means email, scanning, or automatically forwarding bills from your email. Routable wants to enable you to grow into the future, which is why we have a sophisticated API for any bulk processing. When you record encumbrance within your ledger, it makes budget data much more accessible.

BAR CPA Exam: How to Prepare Journal Entries to Record Encumbrances of State and Local Governments

Encumbrances and actual expenditures are distinct concepts in governmental accounting, though they are closely related. An encumbrance represents a commitment to spend funds in the future, but it does not involve the transfer of money. When a purchase order is issued or a contract is signed, the government records an encumbrance to reflect the anticipated expenditure.