The concept is most commonly used in governmental accounting, where encumbrances are used to ensure that there will be sufficient cash available to pay for specific obligations. By using encumbrances, a government entity can be assured that it will not over-extend its finances. A downside of encumbrances is that they increase the complexity of government accounting to some extent. For payroll and purchase order encumbrances, when the vendor or employee is paid, part or all of the encumbrance is released in accordance with that payment. The transaction will appear as an actual expense and the encumbrance will be reduced accordingly. The first step in recording encumbrances is to identify and document all financial commitments.

• Overall, it is essential to recognize the strengths and weaknesses of encumbrance accounting and adapt the practices to suit the specific needs and circumstances of the organization.
• Ultimately, encumbrance accounting helps organizations maintain financial discipline, enhance transparency, and ensure that resources are utilized efficiently and in accordance with their intended purpose.
• As the University prepares to close its fiscal year using OMNI, there are a number of actions departments should take to understand and be prepared for the close.
• To illustrate how the complete encumbrance accounting process works, let’s take a typical example of an encumbrance transaction — a purchase order.

The purpose of encumbrance accounting is to set aside funds for future financial transactions that are yet to be paid. In the realm of accounting, an encumbrance refers to a commitment or obligation to use financial resources for a specific purpose. It represents a portion of allocated funds that are “set aside” or “reserved” for a particular expense or financial obligation. The encumbrance process begins when the companies identify the need to purchase goods or services on credit. At this point in the encumbrance process, a legal obligation to pay vendors has not been established, but there is an acknowledgement of future expenses that need to be paid.

Better Financial Planning

This includes bookkeeping which is either outsourced or done in-house by full-time or part-time employees or contractors. An oversight function is included where an accounting manager reviews the monthly work and discusses financial reports with the owner. Our real estate accounting services are perfect for agents, developers, and property managers. Encumbrances can be established for multi-year awards, where not all budget/funding is available or received in the first year. The PI and department should ensure funds are available for the payments (actuals) expected to hit the general ledger during the current budget period. The remaining outstanding amount of each encumbrance during Fiscal Year End Close will carry over from one year to the next.

Now that we have explored the benefits of encumbrance accounting, let’s consider its limitations. The real estate agent will provide the buyer with a land search document that will have a list of any encumbrances. It is created on the general ledger upon finalization of purchase orders, recurring contracts or pre-encumbrance documents.

Encumbrance Accounting Journal Entries

Despite these challenges, encumbrance accounting remains indispensable for effective financial management. Once the vendor approves the transaction, the commitment converts into a legal obligation. Procurement Services will be responsible for ensuring that department approved orders are completed and dispatched prior to the system becoming unavailable during the year end close process in OMNI.

We’re familiar with many accounting software options and can help you find the best fit for your business. If you’ve outgrown your current solution, we can help you manage the transition without missing a beat. It’s easy to feel that accounting is a necessary evil of doing business, but there are many benefits that can be realized from working with a proactive accounting professional.

Why is encumbrance accounting needed?

Information contained on the University PO is also valuable with regard to understanding what FSU is purchasing, and in providing important information to support FSU’s procurement activities. Our goal is to become a true partner for your business by providing you with the right mix of accounting services for you and your business. To take the first step, give us a call or email us to see how we might best work together for mutual benefit. In the short term, we can also help you create a budget for your business so you can control expenses and see where you stand relative to your goals. We can review the duties of each bookkeeper and make suggestions to procedure changes that will lower your risk and help you better protect your business assets. We can also perform a full risk review and make suggestions to reduce your business risk and strengthen your accounting controls.

AI-powered systems can analyze historical data and make intelligent predictions about future encumbrances, helping organizations anticipate cash flow needs and make more informed financial decisions. Additionally, AI can automate repetitive tasks, such as generating encumbrance reports, freeing up time for finance professionals to focus on more strategic initiatives. As technology continues to evolve, encumbrance accounting systems and software will become more sophisticated, offering organizations increased automation and improved accuracy. These advancements will streamline the encumbrance accounting process, allowing for more efficient tracking of future payments and expenses.