Accountants define an encumbrance as a restriction placed on how an organization uses money. Suppose your city government votes to spend $100,000 on sidewalk repair in three months. Placing the money in an encumbrance account tells city staff the money is committed to the sidewalk project and can't be spent on anything else. [ref1, 2]
TL;DR (Too Long; Didn't Read)
An encumbrance is anything that reserves revenue for a future use, such as a purchase order or a tax debt. Encumbrance accounting is primarily used by governments to avoid overspending the taxpayers' money. [ref2]
A business or government can encumber funds in several ways and for several reasons.
- Writing a purchase order to buy something.
- Signing a contract committing to a purchase of goods or services.
- Setting aside money for tax payments.
- Reserving enough cash to make payroll.
- Reserving money to pay contingent liabilities. These are expenses that may not happen, such as owing damages if you lose a lawsuit. [ref1]
Once the organization creates an encumbrance, it has to record it in the ledgers. Suppose a company has $2 million cash on hand in an appropriated fund. The owner signs a purchase order for $700,000 in new equipment, deliverable in three months. Writing the encumbrance into the ledgers reminds management that the company only has $1.3 million to spend. [ref3, p.1]
Encumbrances are also used in real estate. Property is encumbered when it has a lien on it, or when zoning restricts what it can be used for. This is a separate concept from the accounting term. [ref2]
Encumbrance accounting marks the encumbrance in the organization's accounts once the money is reserved. When it's actually paid out, the bookkeeper zeroes out the encumbrance account and reports the money as a paid expense. [ref1]
Government accounting levies encumbrances against the relevant appropriation account, such as roadbuilding, IT or legal expenses. Paying the expense after money's encumbered doesn't affect the appropriations amount. However if the encumbrance has to be raised or lowered for any reason, that increases or shrinks the appropriations account. [ref3, p.3]
An organization doesn't have to spend the entire encumbered amount in a single purchase. If it's involved in three lawsuits, for instance, it can encumber the contingent liabilities for all three, then pay them out one at a time. [ref4]
Drafting a Pre-Encumbrance
A pre-encumbrance request asks management to set up an encumbrance. For example, the IT department wants to make a purchase of $30,000 in new computer equipment. It makes a pre-encumbrance request to approve the purchase. If management agrees, IT writes a purchase order, which creates the encumbrance. [ref4]