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The encumbrance is marketed in your organization’s accounts once you reserve the money. When the money is paid out, the bookkeeper zeros out the encumbrance account and reports the money as a paid expense. For Purchase Order and Travel Authorization encumbrances, when the vendor or employee is paid, part or all of the encumbrance is released in accordance with that payment.
Your reserve funds should be treated as if they don’t exist, and only dipped into for approved purchases or expenses. Though it may be tempting to leave extra money in the general fund to pull from whenever something comes up, doing so could easily over-extend your budget and place serious constraints on your cash flow. In encumbrance accounting, that number is upfront and easy for any budgeting committee or CFO to examine. By carefully and accurately tracking your encumbrance amounts, you also increase spending visibility.
External Encumbrance
This type of accounting also helps detect fraud, prevent rampant spending, and increases budget control. Once both the purchase requisition and the vendor approve the pricing and order details, the pre-encumbrance phase evolves into the encumbrance phase. Now finalized numbers are in place, and there is a legal obligation to make the payment. This phase is recorded in the general ledger when using encumbrance accounting, even if you did not use the pre-encumbrance stage. Encumbrances are not considered actual expenses and are not included in actual-expense balances. With Encumbrances, no payments leave the University and no actual expense would be generated on a ledger, since it is an expectation of a future actual transaction.
Encumbrance accounting helps your company with budget visibility and analysis by recording planned future payments. Rather than just looking at current transactions, this type of accounting encourages tracking upcoming expenses to help show a more detailed view https://www.bookstime.com/articles/adp-run of your cash flow. Purchase order encumbrances are most commonly used in government accounting, but any organization can use the principle for budgetary control. Using encumbrance entries can serve as a general planning tool and can predict cash outflow.
Explaining the encumbrance accounting process
Pre-encumbrances allow departments to further commit funds to facilitate financial management and are coded with balance type code PE. 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. Paying the expense after the money has been encumbered doesn’t affect the amount of the appropriations. But, if the encumbrance amount has to be altered for any reason, that will either increase or decrease the appropriations account. The External Encumbrance (balance type code EX) refers to the commitment of funds generated by purchase orders.
- Report users can use this encumbrance indicator to evaluate their available balances and solvency concerns, at budget or fiscal year end.
- A downside of encumbrances is that they increase the complexity of government accounting to some extent.
- Encumbrance accounting should not be confused with the term encumbrance in real estate.
- When you need to allot money for a future payment, such as when a purchase order is approved, the encumbrance account is debited.
- A property becomes encumbered once it has a lien on it, or when there are zoning restrictions.
- Purchase order encumbrances are most commonly used in government accounting, but any organization can use the principle for budgetary control.
A property becomes encumbered once it has a lien on it, or when there are zoning restrictions. In Balance Reports, encumbrances can be toggled on or off to reflect available balances. Report users can use this encumbrance indicator to evaluate their available balances and solvency concerns, at budget encumbrance accounting or fiscal year end. If for example, the IT department seeks to purchase $30,000 in new computer equipment, someone in the department will make a pre-encumbrance request to approve the purchase. If management approves, the IT department writes the purchase order, which creates the encumbrance.