What is Encumbrance Accounting?

Encumbrance Accounting Definition

The purpose of encumbrance accounting is to set aside funds for future financial transactions that are yet to be paid.

In other words, encumbrance accounting is like keeping some money separate, or ‘ringfenced’, in the budget and making sure it is only used for that planned expense, nothing else.

Encumbrance accounting is typically used by governments and non-profit organisations, where these encumbrances reserve funds for specific future payments, and therefore guarantee the availability of cash when needed.

This proactive approach allows resources to be managed more effectively and avoids the cash being spent before it is needed.

Encumbrances are recorded in the accounting ledger as a transaction to the encumbrance account.

Once the invoice has been received or paid, the original encumbrance transaction is reversed, and the expense is recorded as normal.

Encumbrance accounting helps with contracts that have been signed, but where no work has actually taken place.

The funds are encumbered so that they aren’t accidently spent on something else.

Encumbrance Accounting Example

Let’s consider a real-world example to show how encumbrance accounting works:

Step 1 – Budget Allocation

A Government creates a budget and allocates £500,000 to be spent on road maintenance throughout the year.

Step 2 – Purchase Order

A purchase order is created for £500,000.

This purchase order covers the anticipated costs, including materials and labour, required for the road repairs.

Step 3 – Encumbrance Entry

At this point, no physical repairs have been completed.

However, in the accounting ledger, the entire £500,000 is recorded as an encumbrance.

The £500,000 is now committed and set aside within the budget specifically for road maintenance purposes only.

This ensures that these funds are earmarked for their intended purpose only, preventing them from being allocated elsewhere.

Step 4 – Payment and Encumbrance Release

As the road repairs proceed and the associated costs accumulate, the actual expenses are incurred.

Therefore, these expenses are offset against the encumbrance that was initially recorded.

Encumbrance Accounting Journal Entries

Using the above example, let’s explore what that would look like in the accounting journal entries:

After the budget is finalised, and the purchase order is raised, we would need to post the encumbrance in the accounting ledger:

Encumbrance Account	Debit	£500,000
Encumbrance Outstanding Account	Credit	£500,000

Then once the work has been completed, we can reverse out the original encumbrance and then pay for the expense as normal:

Encumbrance Account	Credit	£500,000
Encumbrance Outstanding Account	Debit	£500,000
Road Maintenance Expense Account	Debit	£500,000
Cash	Credit	£500,000

Importance of Encumbrance Accounting

Encumbrance accounting is important for a number of reasons:

Better Financial Planning

Anticipating future expenses allows for better allocation of resources by ensuring that funds are available when needed.

This mitigates the risk of insufficient funds and also enables organisations to take advantage of opportunities by having resources readily available.

Expenditure Control

Encumbrance accounting provides a proactive and preventative process for budgetary control.

By allocating funds in advance, and creating encumbrances, organisations can minimise the risk of unintentional overspending.

Accurate Reporting

The use of encumbrance accounting contributes to more accurate financial reporting.

Presenting committed funds in financial statements provides a more complete picture of both current and anticipated financial responsibilities.

This increased level of accuracy is important for both internal decision-making and external reporting requirements.

Increased Transparency

Incorporating encumbrance accounting enhances transparency in financial reporting as stakeholders are given a full insight into the committed funds and planned expenditures.

This transparency promotes accountability, as leaders are held fully responsible for managing resources efficiently.

What is the Difference Between an Encumbrance and an Accrual?

The main difference between an encumbrance and an accrual is that:

Encumbrances are payment commitments for goods and services that have not been received
Accruals are payment commitments for goods and services that have been received

While both encumbrances and accruals involve recognising financial events before cash transactions have happened, they serve different purposes.

Encumbrances are primarily concerned with budgetary control and commitments for future spending, while accruals are related to recognising revenues and expenses in the accounting period in which they are incurred or earned.