Organizations often like to estimate exactly how they will spend funds throughout the year. This helps with the budgeting process and makes the organization more transparent to the public. An encumbrance helps to show expenditures that the entity expects to incur throughout the year.
An encumbrance is a promise to pay a particular amount of money in the future in exchange for a good or service that another person or entity will provide. Most entities, particularly government organizations, use encumbrances so that they can appropriate funds where they are needed. An encumbrance allows the organization to record the anticipation of a future transaction.
Examples of Encumbrances
Contractual obligations, such as a purchase commitment or purchase order, are examples of transactions that will result in an encumbrance. Other examples include taxes payable and payroll commitments. Each of these transactions is chargeable to a particular account, such as payroll, taxes or raw materials.
Recording an Encumbrance
To record an encumbrance, the accountant or bookkeeper debits "encumbrances" and credits "reserved for encumbrances" for the amount that the organization estimates it must pay in the future. A debit increases an asset account and decreases a liability account, while a credit does the opposite. The person that records the transaction will also include information regarding the purpose for the encumbrance. The balance sheet reports encumbrances at year end.
Removal of Contingency
Once the organization receives the good or service, it then pays the provider, thus removing the contingency for payment. The organization then removes the encumbrance from the books and records an expenditure of the exact amount that it paid. To remove the encumbrance, the accountant or bookkeeper uses a reverse entry, crediting "encumbrances" and debiting "reserved for encumbrances." The person then records a debit for the expenditure and a credit to cash or an account payable.