An encumbrance is an accounting term that refers to the funds that have been reserved for, but not yet spent on, specific expenses or obligations. In other words, it’s a claim against funds that have been set aside to cover future payments or liabilities.
This concept is most commonly used in governmental and nonprofit accounting, although it can also be applied in some business settings. It’s typically used in relation to budgeting and expenditure controls, ensuring that a certain amount of money is set aside to cover expected costs.
When an encumbrance is created, an encumbrance account is debited to set aside the required funds. Then, when the actual expense is incurred and paid, the encumbrance is reversed (i.e., the encumbrance account is credited), and the actual expense account is debited.
It’s important to note that an encumbrance itself isn’t an expense and doesn’t show up on the income statement. It represents a reservation of funds, not an actual outflow of cash or resources. It’s typically recorded on the balance sheet or a statement of changes in financial position.
Examples of encumbrances include purchase orders, contracts, or other commitments that will become an expense when goods are received or services are rendered.
Example of an Encumbrance
Imagine a city government is planning to build a new park. The city council approves a budget of $500,000 for the construction of the park. At this point, even though the money has not yet been spent, it becomes encumbered. This means the funds are reserved and cannot be used for other purposes.
The city then signs a contract with a construction company for $400,000. The act of signing this contract represents an encumbrance of $400,000, because the city is now obligated to pay this amount to the construction company. The city’s accounts will reflect this commitment, even though no money has been spent yet.
In the city’s accounting records, an entry will be made debiting an encumbrance account and crediting a reserve (or budget) account for $400,000. This shows that $400,000 of the budgeted funds are now set aside for this specific purpose.
Once the construction company completes the work and is paid, the city will reverse the encumbrance by debiting the reserve account and crediting the encumbrance account for $400,000. Simultaneously, it will record the actual expense by debiting a park construction expense account and crediting cash or accounts payable for $400,000.
This way, the city can keep track of its financial commitments (the encumbrances) separate from its actual expenditures, helping it manage its budget effectively.