Encumbrance Accounting: Ensuring Financial Accuracy and Efficiency

Sticking to budgets and effectively managing finances is of paramount importance to companies. Ensuring you have funds for future expenses is vital to avoid financial issues. Encumbrance accounting helps companies manage their finances better and save for a rainy day. 

Various governments have adopted encumbrance accounting, nonprofits and some companies to handle sensitive finances better. This blog will discuss the importance of encumbrance accounting and how it is performed. 

What is encumbrance?

Encumbrance refers to funds set aside to be allocated for a specific purpose. These expenses are debts which aren’t paid yet but have still been accounted for in encumbrance. Companies can encumber funds in the following ways: 

• Sending purchase orders to vendors or vendor contracts
• Setting aside money for tax payments and mortgage payments
• Saving money for legal expenses that might arise in the future

Encumbrance helps ensure you have enough funds to pay your expenses and enables you to manage and budget better. 

What is encumbrance accounting?

Encumbrance or commitment accounting is the process of accounting for and setting aside funds for future expenses that are yet to be paid. These expenses are recorded in the general ledger as a transaction to the encumbrance account. Once the invoice has been received or paid, the money is transferred to the accounts payable account or vendor’s bank account in the general ledger. 

Encumbrance accounting helps companies track their budget and catch overspending in any category. This helps significantly reduce Maverick spending and save costs. 

Encumbrance is a legally binding agreement to pay money to the vendor. It is created on the general ledger upon finalization of purchase orders, recurring contracts or pre-encumbrance documents. 

Steps in encumbrance accounting

When purchasing goods or services that will be billed later, an encumbrance is noted in the general ledger. Encumbrance accounting is an important factor in accounts payable and procurement functions. Here is how encumbrance intertwines with the procure-to-pay tasks of a company: 

Pre-encumbrance

The encumbrance process begins when the companies identify the need to purchase goods or services on credit. At this point in the encumbrance process, a legal obligation to pay vendors has not been established, but there is an acknowledgement of future expenses that need to be paid. Pre-encumbrance is noted with the help of documents like purchase requisitions, which identify need but aren’t legally binding yet. 

Encumbrance

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. 

Expenditure

When the vendor has delivered the goods or services and an invoice has been sent, the funds are allocated to the accounts payable in the general ledger and the encumbrance account is reduced by the same amount. During year-end closing, the encumbrance funds are either removed if the liabilities no longer exist or are carried on to the following year. These encumbrances are recorded under reserved fund balances in the balance sheet. 

Importance of encumbrance accounting

Encumbrance accounting can help your business in more than one way. Here is why encumbrance accounting is a must in today’s landscape: 

Better financial planning

Encumbrance helps you quickly check funds available for spending and how many funds have been set aside for other expenses. This enables you to allocate budgets to each department and ensure that no money goes out of your funds. 

Expenditure control

Encumbrance or allocating funds for future expenses can help you better plan your funds and costs. It also lets you notice over-budgetary spending and nip maverick tail spending in the bud.

Accurate reporting

Encumbrances are accounted for in the balance sheet as reserved fund balances and can be adjusted or carried forward at the end of a financial year. This helps you accurately report financial data at the end of the year by verifying them and adjusting encumbrances against POs or other documents. 

Increased transparency 

Encumbrance helps you monitor expenditures and allocate funds. This helps improve transparency between departments and ensures every penny has been accounted for with a purchase. Encumbrance also enables you to take control of your finances and prevent fraud from occurring. 

Implementing AP automation for budget control

Implementing the correct AP automation solution to automate your financial processes and ensure each encumbrance is accounted for without increasing your accountants’ manual workload is essential. AP automation solutions like ClearTech let you manage all vendor-related documents like purchase orders and purchase requisitions on a single platform and sync information back to your accounting system once an invoice has been received. This aids your accountants in timely book closing and adding journal entries when an encumbrance has been paid. 

ClearTech also gives you complete visibility into your finances in the form of interactive dashboards and lets you gain control over your budgets. It also helps you grab significant early payment discounts and avoid overspending on your vendor payments.

Conclusion

Encumbrance is the process of setting aside funds for expenses that are legally obliged but haven’t been paid yet. Encumbrance accounting is the process of accounting for encumbrances and recording them in the general ledger as a transaction to the encumbrance account. The funds allocated in this account will not be used for any other purpose. Encumbrance accounting is standard in government and nonprofit organizations to better manage funds and budget expenses. This can be done for future vendor payments against purchase orders or purchase requisitions or can be set aside for tax, mortgage, debt or legal payments. Encumbrance is performed in three steps - pre-encumbrance, encumbrance and expenditure and is recorded in two journal entries. 

This method of accounting helps institutions set better budgets and control overspending and maverick spending. It also increases transparency between departments and aids in correct financial reporting. Implementing AP automation software can significantly help companies sync data for accurate encumbrance accounting and gain control over their finances.