What it means
Imagine a department with a budget of $500,000. If a manager signs a purchase order for $50,000 of equipment, the cash has not left the bank, and nothing appears in the expense account yet.
Without a control, another manager could look at the remaining budget and spend the same money again. Encumbrance accounting solves this.
When a purchase order or contract is approved, the amount is set aside as an encumbrance, which reduces the available budget at once. When the goods arrive and the invoice is paid, the encumbrance is released and replaced by an actual expense.
This approach is most common in government, public sector and charity accounting, where spending limits are set by law or by donors. It is also used in large projects and some corporate budgeting systems.
The goal is to stop overspending before it happens, rather than discovering it afterwards. The key relationship is that available budget equals the approved budget minus actual spending minus encumbrances.
Reports that show only actual spending can be misleading, as they hide commitments that will soon become costs. A budget holder who looks only at actuals may think there is plenty of room when there is not.
In property and lending, an encumbrance has a different meaning. It is a right or claim held by someone else over an asset, such as a mortgage, a lien or an easement, which can limit the owner's ability to sell or borrow against it.
Buyers and lenders check for encumbrances to find out whether the title to a property is clear. Encumbrances are not usually shown as liabilities in the financial statements of a business, because no goods or services have been received yet.
They are management control tools, and in public sector accounts they are often disclosed in the notes or in budgetary reports.
In practice
Real-world examples
Example 1
A city council approves a $2,000,000 contract for road resurfacing in March. The finance system records a $2,000,000 encumbrance immediately, so the highways department cannot spend that part of its budget on anything else. Payments are made in stages as the work is completed.
Example 2
A university research team has a $400,000 grant. The team places orders for laboratory equipment worth $90,000 and signs a $60,000 contract with a consultant. Both are recorded as encumbrances, so the remaining grant shown to the principal investigator is $250,000 less any actual spending to date.
Example 3
A buyer purchases an office building and the legal check shows an existing mortgage and a right of way held by a neighbour. These encumbrances affect the property's value and the buyer's use of it. The buyer negotiates a lower price and requires the seller to discharge the mortgage at completion.
Think of it
An encumbrance reserves budget money for something you've ordered but not yet received or paid for.
Formula
Calculation
Available budget = Approved budget - Actual expenditure - Encumbrances
Suppose a department has an approved budget of $500,000, has spent $180,000, and has open purchase orders totalling $120,000 that have not yet been delivered or paid.
Available budget = 500,000 - 180,000 - 120,000 = $200,000.
If a manager wants to place a new order for $230,000, the system would reject it because it exceeds the $200,000 still available.
When the $120,000 of goods arrive and are paid for, the encumbrance falls to zero, actual expenditure rises to $300,000 and the available budget stays at $200,000.Case study
Seen in the real world
Marsh County Schools is an illustrative, fictional public body that tracked only actual spending against its annual budget. In March the finance office reported $600,000 remaining in the supplies budget.
Principals then placed orders for textbooks and furniture, unaware that $540,000 of earlier purchase orders were still open. When the invoices arrived, the budget was overspent by $180,000 and the district had to cut other spending to compensate.
The following year the finance office introduced encumbrance accounting, so each approved order reduced the available balance on the spot. The illustrative lesson is that a budget report without commitments gives a false sense of security.
Watch out
Common mistakes
- Treating an encumbrance as an expense or a liability, when it is only a commitment that has not yet been delivered.
- Forgetting to release the encumbrance when the invoice is paid, which double-counts the spending.
- Checking the budget using actual spending alone and ignoring open orders.
Questions
People also ask
What is the difference between an encumbrance and an expense?
An encumbrance is a commitment to spend, recorded when an order is approved, while an expense is recorded when goods or services are received.
Where are encumbrances most commonly used?
They are widely used in government, public sector and not-for-profit accounting, and in project budgeting where spending limits must be strictly enforced.
What does encumbrance mean for property?
It is a claim or restriction on an asset, such as a mortgage, lien or easement, that can limit the owner's right to sell or use it freely.
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