Finance leaders often put controls in place to manage and predict spending, from limiting access to company cards to dynamic budgets to real-time forecasting software.
One such way to maintain budget control is to use encumbrances.
An encumbrance is essentially an amount of money that has been reserved for future use. You haven’t incurred the expense yet, and you haven’t paid for it, but you’ve put the funds aside for that specific future expense.
In this article, we’ll dive deep into the world of encumbrances. We’ll explain what they are, discuss how encumbrance accounting works, and explore best practices for managing encumbrances in your own business to prevent overspending and improve visibility.
What is encumbrance accounting?
In accounting, an encumbrance refers to funds that have been reserved for a specific future expense.
Encumbrances represent commitments to spend money in the future. It's not a prepaid expense, as the cash hasn’t left your account, nor is it an accrued expense, as it also hasn’t been incurred. It's simply a recognition of funds that are expected to be spent at a later date.
Common examples include purchase orders, contracts, or salary obligations. Basically, any situation where an organization knows it will owe money but hasn’t disbursed it yet can be a prime situation for encumbrance accounting.
Encumbrance accounting helps organizations (especially those in the public and nonprofit sectors) to track and manage financial commitments ahead of time to prevent overspending and maintain budget control.
What is an encumbrance?
Encumbrance accounting is a financial management method that tracks committed funds before they become actual expenditures.
Using encumbrance accounting, accountants record obligations such as purchase order contracts as soon as they are made. This allows organizations to reserve portions of their budget in advance to prevent overspending.
It's a system that is especially useful in sectors that have strict budget compliance requirements, such as:
- Government agencies
- Educational institutions
- Nonprofits
Let’s illustrate with an example.
Say a university issues a purchase order to buy lab equipment for $50,000. They haven’t paid for it yet or even received an invoice.
However, the amount is recorded as an encumbrance immediately, reserving that $50,000 for the upcoming expense. Once the equipment arrives and is invoiced, the encumbrance is lifted and replaced with an actual expense.
Encumbrance accounting vs. traditional accounting
Unlike in traditional accounting, which records transactions only after they occur, encumbrance accounting provides something like an early-warning system, allowing finance teams to track spending commitments in real time.
This proactive approach plays a critical role in financial management, especially for organizations operating under tight fiscal controls or fixed annual budgets.
Recognizing encumbrances during the budgeting process helps organizations avoid overspending by clearly showing which funds are already committed. It gives finance teams visibility into remaining available funds and helps ensure compliance with internal and external spending limits.
The encumbrance accounting process
The encumbrance accounting process follows a series of steps that help organizations track spending commitments before they turn into actual expenses. Each company might have a slightly different workflow, but here’s how it typically works:
- Pre-encumbrance (optional step). When a department identifies a future need, such as new equipment, then submits a requisition, this signals an intention to spend and can be tracked internally as a pre-encumbrance to aid planning.
- Create an encumbrance. Once the purchase requisition is approved, the purchase order and/or contract is issued, and the organization records the encumbrance. This officially reserves part of the budget for the anticipated expense.
- Track the encumbrance. The encumbrance will remain on the books until the goods or services have been received, along with an invoice. This will help ensure the funds aren’t accidentally spent elsewhere and will allow finance teams to keep on top of outstanding commitments to ensure the business doesn’t overcommit to future spending.
- Convert to actual expense. Once the vendor delivers the goods or services and an invoice is received, the encumbrance is left, and the obligation is recorded as an actual expense.
- Reconcile and report. Effective finance teams review encumbrance activity regularly to ensure accuracy, resolve discrepancies, and generate reports showing both committed and available funds.
How to adjust encumbrances as transactions occur
Encumbrances aren’t static. In fact, they need to be updated as circumstances change.
Throughout the procurement and payment process, adjustments may be required to ensure the accounting records reflect current obligations.
The most common of these include:
- Partial fulfillment: If only part of an order is delivered, the encumbrance is reduced by the amount received and remains open for the balance.
- Price changes: If the cost of goods or services changes before delivery, the encumbrance should be updated to reflect the new amount.
- Cancellations: If a purchase order is cancelled, the encumbrance must be reversed to release the reserved funds back into the available budget.
- Errors: Mistaken entries should be corrected promptly to avoid misreporting or tying up funds unnecessarily.
By keeping encumbrances up-to-date, finance leaders can ensure accurate budget visibly, allowing them to manage cash flow and spending with confidence.
Best practices for managing encumbrance accounting
Encumbrance accounting is a helpful system, but it can go awry. To avoid common mistakes, organizations should follow these key best practices:
- Standardize policies: Develop clear internal guidelines for when and how to record encumbrances, including thresholds and approval workflows.
- Integrate your encumbrance log with budgeting tools: Use budgeting software that links encumbrances directly to the spending plan, enabling real-time tracking of commitments and remaining funds.
- Invest in upskilling your team: Train staff to ensure procurement, finance, and department managers understand how encumbrances work and their role in maintaining accurate records.
- Keep an eye on encumbrances: Review encumbrance reports frequently to catch outdated or unused encumbrances, which can tie up funds and distort budget availability.
- Regularly audit the process: Conduct periodic audits to ensure encumbrances are being recorded, adjusted, and cleared correctly. Adjust processes as required.
Is encumbrance accounting right for your organization?
Encumbrance accounting can be a helpful way to tighten budgetary control and prevent overspending.
While it is most commonly applied in government, educational, and nonprofit institutions, it can be a helpful system to employ in any organization looking to tighten up spending.
While you’re gearing up to get on top of expenditure, check out BILL Spend & Expense.
Our integrated expense management software is packed with powerful features for controlling spend, such as:
- Automate expense reports
- Virtual spending cards
- Automatically enforced spending limits
- Access to business credit
- Easy employee reimbursements
Frequently asked questions
Why is encumbrance accounting important?
Encumbrance accounting has one big benefit: it helps organizations manage their budgets more effectively.
By showing committed funds before actual spending occurs, accountants, finance professionals, and business leaders gain a clearer picture of available resources, prevent overspending, and support better financial planning.
This is especially important in public sector and nonprofit settings.
What is the difference between encumbrance and accrual?
An encumbrance is a commitment to spend money in the future. It may be formalized with a purchase order or signed contract, but no invoice is received, and no cash changes hands.
An accrual, on the other hand, is an expense that has been incurred but not yet paid, such as goods that have been received but are awaiting payment.
While encumbrances are forward-looking, accruals reflect past obligations.
Is encumbrance an asset or a liability?
Encumbrances actually aren’t classified as assets or as liabilities on the balance sheet.
Instead, they’re generally tracked in budgetary accounting systems that sit outside of the company’s official records.
How do you record encumbrance in accounting?
When an encumbrance is created, it's not recorded in the general ledger. Instead, it's recorded in a separate budgetary ledger.
A typical entry might debit an "Encumbrance" account and credit a "Reserve for Encumbrances" account, signaling that funds are earmarked but not yet spent. Once the expense occurs, the encumbrance is reversed and replaced with the actual expenditure entry.
