An Introduction to Encumbrance Accounting & The Encumbrance Process
Organizations use budgetary controls to minimize maverick spending and avoid overspending. Encumbrance accounting may be part of budgetary control. It allows government entities, nonprofits, and some businesses to more effectively monitor and control how much they spend. They’re better able to keep their expenditures within the allocated budget and more accurately predict cash flow.
This article explores the practice of encumbrance accounting, its importance, and how a typical encumbrance accounting process works.
To better understand encumbrance accounting, let’s first explore the term “encumbrance.”
What is an Encumbrance?
In accounting, an encumbrance is an open commitment to pay for goods or services ahead of the actual purchase. In other words, the purchasing company makes a promise to pay before the expense is incurred. Once the transaction is approved, the commitment becomes legally binding. That is, the purchaser becomes legally obligated to make the payment.
Encumbrances are also known as pre-expenditures since they act as budgeted reserve funds before the actual expenditure. While appropriations are money set aside for budgetary line items, encumbrances are reserves for a specific item. Some examples of encumbrances are utility payments, tax payments, and payroll.
The definition of an encumbrance is not the same as used in the real estate profession, where it means mortgages, property liens, and easements.
What is Encumbrance Accounting?
Encumbrance accounting is also referred to as commitment accounting, which involves setting aside money ahead of time to meet anticipated expenses. The amount is set aside by recording a reserve for encumbrance account in the general ledger. This is to ensure that the organization has sufficient funds to meet anticipated payment obligations.
Encumbrance accounting is often used as a planning tool for budgetary control, particularly in government organizations using government accounting standards and nonprofits.
Budgetary control involves additional processes such as validating transactions to determine whether spending is permissible or whether sufficient funds are available. Encumbrance accounting is only concerned with creating encumbrance journal entries for documents such as purchase requisitions and purchase orders.
Encumbrance entries are primarily recorded to monitor expenditures and to ensure that the allocated budget is not exceeded. Consequently, it ensures accounting for the anticipated expenditure is done.
Typically, there are two ways of using encumbrances to monitor overspending. One way is to look for over-expenditures in reports generated after posting actuals and encumbrances. The other is to identify potential over-expenditures before they occur by verifying whether the budget has sufficient funds to cover the actual and hidden costs.
Financial statements indicate how budgetary resources are allocated to payment commitments before the actual expenditure incurs with encumbrance accounting. By enhancing expenditure control with encumbrance accounts, government entities and some businesses can reduce maverick spending, increase spending under management, improve budget planning, and more accurately predict cash outflow.
What Does the Encumbrance Accounting Process Look Like?
Encumbrance accounting is closely associated with the Procure-to-Pay (P2P) process, from creating purchase requisitions to recording the actual expenditure.
Encumbrance accounting involves recording encumbrances in the general ledger when the organization is certain about the time and amount of the anticipated expense. This is done before creating and collecting the underlying documents, such as purchase requisitions and purchase orders.
Encumbrance accounting has three main phases, in line with those for procuring goods or services.
Phase 1: Pre-encumbrance (Commitment)
The procurement process begins with the intent to purchase goods or services. This intent implies that the business is highly likely to spend money in the future, which implies a commitment to make a purchase. However, at this stage, there is no legal obligation to make a payment. An example of a pre-encumbrance transaction is a purchase requisition.
Phase 2: Encumbrance (Obligation)
Once the vendor approves the transaction, the commitment converts into a legal obligation. The procuring organization becomes liable to make a payment in the future. An example of an encumbrance transaction is the approval of the purchase order.
Phase 3: Expenditure (Realization)
In the final stage, the actual transaction occurs. That is, the supplier delivers the goods or services. Then, the procuring company converts the encumbrance into an expenditure by transferring the transacted items from the encumbrance account into accounts payable.
In practice, encumbrance accounting consists of two main steps. The first step is to encumber the new items to the general ledger. The main currency used by the organization to conduct its operations is used when encumbering the items. In the second step, the items are unencumbered once they’ve been transferred to accounts payable.
To illustrate how the complete encumbrance accounting process works, let’s take a typical example of an encumbrance transaction — a purchase order.
When an organization creates a new purchase order or adds a new line item to an existing purchase order, the new items are encumbered to the journal. An entry is made in the journal with a debit to the encumbrance account and transferred to the general ledger.
After the vendor accepts the purchase order and delivers the goods or services, the purchasing organization becomes liable to make the payment.
The purchasing company spends the encumbered amounts after confirming vendor invoices referring to the purchase order. This results in a credit of the invoice amount to the encumbrance account, reducing its balance.
The procuring organization may spend all of the encumbered amount or only a portion. However, according to GAAP, outstanding encumbrances in the year-end are not considered expenditures for the fiscal year.
Why Is Encumbrance Accounting Important?
Organizations account for future expenditures by enforcing budgetary controls and monitoring spending.
With encumbrance accounting, future payment obligations are recorded in financial documents as projected expenses. This allows organizations to determine the amount of funds available for future spending. As a result, they’re able to avoid exceeding the allocated budgets and minimize overspending.
Many businesses achieve budgetary control instead of using encumbrance accounting by comparing budgeted accounts by responsibility center and the resulting financial statements with actual amounts (including actual expenses). The companies track and analyze differences as favorable and unfavorable variances.
In some cases, businesses may enter into a large contract or have debt or loan repayment that results in restricted cash balances held aside for specific purpose expenditures. Restricted cash is a type of business encumbrance requiring unique accounting. The FASB gives guidance for reporting restricted cash on the balance sheet and in cash flow statements.
With encumbrance accounting, organizations record anticipated expenditures beforehand. This encourages transparency and increased visibility in how the budget is being allocated and how money is being spent. As a result, organizations can track their expenditures against the allocated budget more effectively.
Encumbrance accounting helps them reduce maverick spending and improve spend management, minimizing leakage of cost savings.
Encumbrance accounting primarily allows nonprofits and government organizations to record and monitor all future and planned expenses. As a result, they’re able to predict cash outflows more accurately. Encumbrance accounting acts as a budgeting tool, resulting in more effective planning, allocating, and controlling their budgets.