What Is an Encumbrance in Governmental Accounting?

Governmental accounting operates under a distinct framework compared to private sector accounting, primarily due to its focus on accountability for public funds rather than profit generation. Public entities, such as federal, state, and local governments, manage taxpayer money and adhere to strict legal and budgetary mandates. These mandates necessitate specialized accounting practices to ensure transparency and compliance with appropriation laws. This unique environment shapes how financial transactions are recorded and reported, leading to concepts like encumbrances.

Understanding What an Encumbrance Is

An encumbrance in governmental accounting represents a commitment of funds for a future expenditure. It is a reservation of a portion of an approved budget, signaling these funds are designated for a specific purpose before actual payment. This commitment arises when a government entity formally agrees to purchase goods or services, such as when a purchase order is issued or a contract is signed. For instance, if a city government issues a purchase order for new office supplies, that amount becomes an encumbrance, setting aside those funds.

This action reduces the available budget balance, indicating the committed funds are no longer available for other uses. Encumbrances are not actual expenses; instead, they track obligations before they become liabilities.

Why Governments Utilize Encumbrances

Governments utilize encumbrances for budgetary control and financial planning. This practice helps ensure sufficient funds are available to meet future financial obligations, preventing overspending of allocated appropriations. Encumbrances provide a clear understanding of an entity’s outstanding commitments, promoting transparency in financial reporting. They allow government managers to see the true “available” balance of their budget, which is the total appropriation minus both actual expenditures and outstanding encumbrances. This mechanism helps in making informed decisions about future spending and resource allocation.

The Lifecycle of an Encumbrance

The lifecycle of an encumbrance begins when a government entity makes a formal commitment for goods or services, such as issuing a purchase order or signing a contract. The corresponding amount is “encumbered” in the accounting system, reserving funds within the budget and reducing the amount available for other spending. When the goods or services are received and an invoice is approved, the encumbrance is “liquidated” or reversed. The actual expenditure is recorded, replacing the earlier commitment.

For example, if a department encumbered $5,000 for a service and the final invoice is for $4,900, the $5,000 encumbrance is reversed, and an expenditure of $4,900 is recorded. Any difference between the encumbered amount and the actual expenditure is released back into the available budget. If goods or services are not received by the end of the fiscal year, some encumbrances may lapse, meaning the reserved funds become available again in the new budget year, or they may carry over depending on specific governmental accounting policies.

Encumbrances Versus Expenditures

Encumbrances and expenditures are distinct concepts in governmental accounting. An encumbrance represents a commitment or reservation of funds for a future purchase, setting aside budgeted money. It is a forward-looking measure, indicating an intent to spend based on an order or contract.

In contrast, an expenditure signifies the actual outlay of funds for goods or services that have already been received. This occurs when a liability is incurred or cash is paid, representing a completed transaction. The key difference lies in timing and the nature of the financial event: an encumbrance precedes an actual payment, while an expenditure is the payment itself or the recognition of a liability for services rendered.

Encumbrances are not reported on standard financial statements like the balance sheet or income statement, as they are not liabilities in the traditional sense. Instead, they are disclosed in notes to the financial statements or in supplementary schedules to provide transparency about budgetary commitments. Expenditures, however, are recorded as actual expenses on financial reports, affecting fund balances and overall financial position.