Encumbrances

It also increases transparency between departments and aids in correct financial reporting. Implementing AP automation software can significantly help companies sync data for accurate https://www.bookstime.com/ and gain control over their finances. 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.

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. Government agencies must navigate complex procurement processes and comply with various accounting regulations.

Explaining the encumbrance accounting process

Once the vendor approves the transaction, the commitment converts into a legal obligation. One way is to look for over-expenditures in reports generated after posting actuals and encumbrances. The other is to identify potential over-expenditures before they occur by verifying whether the budget has sufficient funds to cover the actual and hidden costs.

• Encumbrance accounting acts as a budgeting tool, resulting in more effective planning, allocating, and controlling their budgets.
• With encumbrance accounting, future payment obligations are recorded in financial documents as projected expenses.
• By tracking this information, financial analysis is easier to perform and a more accurate predictor.
• If it’s involved in multiple lawsuits, for example, it can encumber the potential liabilities for all of them, and then pay them out one at a time.
• Encumbrance accounting, therefore, ensures that a business does not overspend its budget.

These expenses have not been billed yet, but money has been set aside from the company’s budgets. During year-end closing, the encumbrance funds are either removed if the liabilities no longer exist or are carried on to the following year. These encumbrances are recorded under reserved fund balances in the balance sheet. 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. Pre-encumbrance is noted with the help of documents like purchase requisitions, which identify need but aren’t legally binding yet.