Demystifying Encumbrance Accounting: Definition And Recording

When the city council approves a contract for the work, that $100,000 becomes encumbered. If the project ends up costing only $90,000, the remaining $10,000 is released from encumbrance and can be reallocated. Encumbrance accounting, when properly implemented, allows for financial information to be seen and analyzed much quicker than a “budget to actual” accounting process.

What Is Encumbrance Accounting?

The PI and department should ensure funds are available for the payments (actuals) expected to hit the general ledger during the current budget period. The remaining outstanding amount of each encumbrance during Fiscal Year End Close will carry over from one year to the next. 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.

• This encumbrance does not affect the financial statements in the same way that an actual expenditure would, but it does reduce the available budgetary balance.
• These commitments are recorded in budgetary accounts, not in the primary financial statements.
• This involves debiting the Budgetary Fund Balance – Reserved for Encumbrances account (to release the reserved portion of the budget) and crediting the Encumbrances account (to reverse the commitment).
• Encumbrance accounting or commitment accounting is a budgetary control method used to ensure that money is set aside for future financial expenses or commitments.
• This ensures that the project can proceed without financial interruptions, and any changes in cost estimates can be addressed promptly by adjusting the encumbrances.
• Encumbrances represent commitments for goods or services that have not yet been delivered or paid for, and these obligations often extend into the next fiscal period.

Increased transparency

• As a result, they’re able to avoid exceeding the allocated budgets and minimize overspending.
• In this case, the entity would reduce the encumbrance to match the updated purchase order or contract value.
• This naming makes more sense when you realize that encumbrance enables budgetary control by recording money that is allocated for future projects, preventing over-expenditure of a budget.
• Implementing AP automation software can significantly help companies sync data for accurate encumbrance accounting and gain control over their finances.

Encumbrances provide a transparent view of available funds, aiding in strategic planning and resource allocation. When a vendor has been selected, and a purchase order or recurring purchase has been set up with the vendor, the payment becomes legally due. The funds allocated for the purchase can now not be used for any other purpose or aren’t taken back from the encumbrance account by the company. Financial controllers, on the other hand, monitor encumbrances to manage cash flow effectively. They need to ensure that while funds are set aside for encumbrances, sufficient liquidity is maintained for day-to-day operations. From the perspective of a budget officer, the encumbrance process begins with the creation of a purchase order https://www.bookstime.com/ (PO).

Balancing Governmental Budgets Under GASB 54

At the end of the year, if you have a balance remaining in the encumbrance reserve account, you’ll need to determine if those contra asset account commitments are still valid or if they will need to be adjusted. After the vendor accepts the purchase order and delivers the goods or services, the purchasing organization becomes liable to make the payment. The changes to the general fund, debt service fund and capital project fund definitions are minor and, in most cases, just reflect the new terms of restricted, committed and assigned included in this standard. The encumbrance concept is also used in real estate, where it is a claim against a property.

How Adjustments Are Made if There Are Changes in the Purchase Order

• The encumbrance accounting entry is done for funds set aside for future expenses that are liable to be paid.
• Encumbrances should be monitored regularly to ensure accurate tracking of financial commitments.
• Using encumbrance accounting, accountants record obligations such as purchase order contracts as soon as they are made.
• You’ll need to complete two entries at this time, the first to reverse the encumbrance you created.

Recognizing encumbrances during the budgeting process helps organizations avoid overspending by clearly showing which funds are already committed. It gives finance teams visibility into encumbrance accounting remaining available funds and helps ensure compliance with internal and external spending limits. Incorporating encumbrance accounting enhances transparency in financial reporting as stakeholders are given a full insight into the committed funds and planned expenditures. With encumbrance accounting, organizations record anticipated expenditures beforehand.

Encumbrances and Financial Reporting

As governments worldwide strive for better fiscal health, encumbrance accounting stands out as a key tool in achieving that goal. Understanding the encumbrance process from these various perspectives ensures that all stakeholders are aware of their roles and responsibilities in maintaining fiscal responsibility. From the perspective of a financial controller, encumbrance accounting is a tool for maintaining fiscal discipline. It ensures that departments adhere to their budgets and do not commit to expenditures that exceed their allocations.

• This system is designed to help governments manage their resources effectively and maintain compliance with legal budget requirements.
• This encumbrance is recorded, reducing the available budget and signaling to other departments that those funds are committed.
• Encumbrance accounting is a method used to track and record commitments made by an organization for future expenses.
• Under GASB, encumbrances are not considered liabilities because no goods or services have yet been received.
• Encumbrances provide a transparent view of available funds, aiding in strategic planning and resource allocation.

These expenses have not been billed yet, but money has been set aside from the company’s budgets. Proactive budgeting stands as a beacon of strategic financial planning, illuminating the path to fiscal stability and accountability in government institutions. It’s a forward-thinking approach that anticipates expenses and allocates funds accordingly, ensuring that resources are available when needed. This method contrasts sharply with reactive budgeting, which often leads to rushed decisions and financial shortfalls.

Importance of Recording Encumbrances to Prevent Overspending and Ensure Funds Are Properly Allocated

This integration of technology has transformed encumbrance accounting from a static record-keeping exercise into a dynamic financial management tool. Encumbrance accounting is a budgeting technique that can revolutionize the way governments manage their finances. By earmarking funds for specific purposes before the actual expenditure occurs, this method ensures a more disciplined and transparent approach to fiscal management. It acts as a financial guardrail, preventing overspending and fostering a culture of accountability among departments. The benefits of implementing encumbrance accounting are manifold and touch upon various aspects of governmental operations. When tracking your transactions and expenses, it is crucial to reflect your cash flow on your general ledger accurately.