Encumbrance accounting helps your company with budget visibility and analysis by recording planned future payments. Instead of only looking at current transactions, this type of accounting encourages tracking upcoming expenses to help show a more detailed view of your cash flow.
When tracking your transactions and expenses, it is important to reflect your cash flow on your general ledger accurately. Accurate financial reporting in both accounts payable (AP) and accounts receivable (AR) helps the company accurately reserve funds for items like tax payments, payroll, real estate acquisitions, and other miscellaneous projects and invoices. Key analysis, reports, and audits are based on the cash outflow and journal entries tracked by accounting, making accurate tracking much more than a simple general planning tool.
With how important an accurate fund balance is, there are many ways accounting teams have tried to track this data. One type of accounting that hopes to anticipate future budgets better and provide budgetary control options is encumbrance accounting. From the setup of a more precise budget amount to avoiding red spending flags, encumbrance accounting can help your company have more accurate and helpful general book sets.
TLDR:
- Encumbrance accounting reserves funds for future payments on your general ledger before money is spent.
- The process runs three stages: pre-encumbrance, encumbrance, and expenditure, each with a distinct ledger entry.
- Tracking encumbrances prevents overspending by showing committed funds as part of your projected expenses.
- A department with $50,000 in active encumbrances against a $60,000 budget has only $10,000 actually available.
- Routable supports payment tracking and audit trails that complement encumbrance-based budget controls.
What Is Encumbrance Accounting?
Encumbrance journal entries and accounting are also sometimes called commitment accounting. This naming makes more sense when you realize that encumbrance supports budgetary control by recording money that is allocated for future projects, preventing over-expenditure of a budget.
Manual encumbrance lines are made on the general ledger, most commonly after a purchase requisition process. Once a purchase order (PO) goes through the approval process, the encumbrance transaction then shows the money appropriations for that purchase. Any unpaid encumbrances at the end of the year processing, such as outstanding purchase orders, are reviewed and may carry to the first period of the following year.
What Is an Encumbrance?
An encumbrance, also called a pre-expenditure, is a method of tracking future period payments prior to the finalization of the project or the receipt of goods. Think of encumbrances as reserved funds to cover pre-determined liabilities before they come due. There are different encumbrance types, ranging from reserves for payroll to money set aside by budgetary control groups for things like contingency expenses.
The accounting term encumbrance can sometimes be mistaken for real estate encumbrance. When a real estate property has a lien or easement, it is considered encumbered. The real estate term has nothing to do with encumbrance entries in accounting.
What Is an Example of an Encumbrance?
One of the most common examples of an encumbrance is the money allotted when you create a purchase order for services or items from a vendor. When you make the PO, you then will generate an entry indicating the encumbrance or the money you will pay in the future for that order. Once you pay that supplier’s invoice, you will remove that money from within the encumbrance balance.
Other examples of encumbrance can include money set aside for payroll, allotted cash for monthly fees such as utilities or rent, and cash that is set aside for taxes or other longer-term fees. It is up to your company to decide which items will be the most helpful for them to track to more accurately predict and track cash flow.
Is Encumbrance a Debit or Credit?
Encumbrance is considered a debit balance account. When you need to allot money for a future payment, such as when a purchase order is approved, the encumbrance account is debited. In the future, when you pay that sum off, the encumbrance account is credited.
Explaining the Encumbrance Accounting Process
Encumbrance accounting, when properly implemented, allows for financial information to be seen and analyzed much quicker than a “budget to actual” accounting process.
Step 1: Pre-Encumbrance
During the initial pre-encumbrance phase, someone submits a request to reserve money for a future payment. At this stage, the funds have been requested but not yet approved for purchase. Accounting sometimes will track these requests in the general ledger. Then, when that request is approved, a purchase order can easily be made for the exact amounts. When the encumbrance amount gets added to the general ledger, you can remove the payment from the pre-encumbrance amount. This phase often begins when a purchase requisition is put in for approval.
Step 2: Encumbrance
Once both the purchase requisition and the vendor approve the pricing and order details, the pre-encumbrance phase evolves into the encumbrance phase. Now finalized numbers are in place, and there is a legal obligation to make the payment. This phase is recorded in the general ledger when using encumbrance accounting, even if you did not use the pre-encumbrance stage.
Step 3: Expenditure
Within the expenditure phase, the order has been fulfilled. Your company has received the goods or services that were initially ordered and now must pay back the supplier’s invoice. This receipt and matching process is closely related to 3-way matching in accounting, where the purchase order, receiving report, and invoice are verified against each other before payment. Money from the encumbrance account is moved into the appropriate account to pay the invoice, and accounts payable handles the payee disbursement.
|
Phase |
Trigger |
Ledger Entry |
Budget Impact |
|---|---|---|---|
|
Pre-Encumbrance |
Purchase requisition submitted |
Optional: tracked informally or as a memo entry |
Flags potential future spend; no firm commitment yet |
|
Encumbrance |
Purchase order approved by both parties |
Encumbrance account debited; budgetary fund balance credited |
Available budget reduced by the full PO amount |
|
Expenditure |
Goods or services received; invoice submitted |
Encumbrance reversed; actual expense recorded at invoice amount |
Budget reflects real spend; any variance is noted and cleared |
Why Is Encumbrance Accounting Needed?
Encumbrance accounting has many benefits for a company, including better visibility, improved expenditure control, and more precise analysis. This type of accounting also helps detect fraud, prevent rampant spending, and increases budget control.
Increased Visibility
By carefully and accurately tracking your encumbrance amounts, you also increase spending visibility. It reduces unnecessary spending when tracked this way and can help catch any fraudulent purchases more quickly. Overall, it can assist in making purchasing information more transparent and easily accessible when needed to support tracking and overspending prevention.
Accurate Expenditure Control
Encumbrance data supports budgetary control, letting your company better understand where they are financially at any given time. Since the money that the company will spend later is tracked, a company can keep from overspending by showing open commitments as part of projected expenses. By making visible the amount of money you plan on spending in the future, you can more accurately see how much money you can spend on future projects or purchases without going over budget.
While there are other ways to check this amount, such as checking your actual expenses against your approved purchase orders or other factors, it is often less accessible and takes more work to see the exact number. In encumbrance accounting, that number is upfront and easy for any budgeting committee or CFO to review.
Enhanced Analysis
When you record encumbrance within your ledger, it makes budget data much more accessible. By tracking this information, financial analysis is easier to perform and a more accurate predictor. When your analysis is more precise, your estimated cash outflow will reflect your company’s position more truly.
Final Thoughts on the Encumbrance Accounting Process
Looking for other ways to increase your accounting’s accuracy and analytics? Consider investing in automation tools like Routable. Our platform helps you simplify your AP, eliminating manual errors and allowing for better tracking of your payments and payees. Routable provides a complete audit trail to help lower fraud and compliance risk and helps increase visibility through this thorough tracking. We also allow you to process your invoices and payments your way, whether that means email, scanning, or automatically forwarding bills from your email. Routable is built to help you grow into the future, which is why we have a sophisticated API for any bulk processing.
Are you interested in finding out more about how automation can empower your team and increase your visibility and expenditure control? Request a demo.
FAQ
What is the difference between pre-encumbrance and encumbrance in accounting?
Pre-encumbrance records a spending request before it receives formal approval. No legal obligation exists yet, and the entry may be tracked informally or as a memo line. Encumbrance kicks in once both parties approve the purchase order, creating a firm legal commitment that reduces your available budget and appears as a debit on the general ledger.
How does encumbrance accounting prevent a department from overspending its budget?
Encumbrance accounting reduces your available budget the moment a purchase order is approved, not when the invoice is paid. A department with a $60,000 quarterly budget and $50,000 in active encumbrances has only $10,000 actually available to commit. That constraint is visible in real time, so it never surfaces as a surprise deficit after funds are already spent.
What happens when a vendor invoice comes in higher or lower than the original purchase order amount?
When the final invoice differs from the encumbrance, you reverse the original entry in full and record the actual expense at the correct figure. If the invoice is lower, the difference releases back to your available budget. If it is higher, the overage posts as an additional expense and gets flagged for budget review. Tracking these variances consistently is how finance teams improve the accuracy of future purchase requisitions.
Should I use encumbrance accounting or a “budget to actual” approach for tracking committed spend?
Encumbrance accounting gives you a faster, more accurate picture of available funds because committed amounts are reserved on the ledger before money moves. A budget-to-actual approach only captures what has already been paid, meaning your available balance looks higher than it actually is. That gap is a meaningful risk when you are managing multiple concurrent purchase orders or running period-end close across a large payee network.
How does Routable support the payment tracking and audit visibility that encumbrance-based budget controls require?
Routable provides real-time payment status tracking and a complete audit trail across every disbursement, which complements the commitment-based visibility that encumbrance accounting creates on the ledger side. When your general ledger flags an encumbrance as fulfilled, Routable’s payment confirmation records and reconciliation data give your finance team the supporting documentation to close that entry cleanly, without manual follow-up or reconciliation gaps.
