What it means
In standard business accounting, expenses are typically recorded when an invoice arrives or when payment is made. However, this leaves a dangerous gap between ordering something and paying for it, during which you might accidentally spend the same money twice.
Encumbrance accounting solves this problem by introducing a holding stage. When you commit to a purchase, such as signing a contract or issuing a purchase order, you create an encumbrance.
This sets the money aside in your ledger, reducing your available balance immediately, even though the cash has not left your bank account yet. The practice is especially vital for organisations with strict budgets, such as government agencies, non-profits and larger small businesses.
Without encumbrance accounting, managers look at their financial reports and see a large pool of available cash, unaware that several big orders are already in transit. By recognising committed funds early, decision-makers get a realistic view of their true financial standing.
It stops departments from making competing purchases that exceed their allocated limits. In practice, the lifecycle of a transaction under this system has three main steps.
First, you create the encumbrance when placing an order. Second, you liquidate that encumbrance and turn it into an actual account payable when the goods arrive and you receive the invoice.
Third, you clear that payable when the final payment is sent. This careful tracking ensures total visibility over every dollar, giving business owners peace of mind and preventing nasty end-of-month budget surprises.
Imagine reserving a table at a busy restaurant by putting down a deposit. That table is now off-limits to other walk-in customers, even though you have not ordered your meal yet, and encumbrance accounting works the same way for your business budget.
In practice
Real-world examples
Example 1
A digital marketing agency issues a purchase order for five new laptops costing $1,000 each. Encumbrance accounting immediately earmarks $5,000, so that money cannot be spent elsewhere, even though the laptops will not be delivered for two weeks. The department head can see the reduced balance on her budget report the same day.
Example 2
A small manufacturing firm signs a contract for raw materials valued at $12,000. The finance team logs an encumbrance to protect those funds until the delivery and invoice arrive next month. When the invoice arrives for $12,000, the encumbrance is replaced by an account payable of the same amount.
Example 3
A local charity commits $3,000 to sponsor a community event venue. Encumbrance accounting reserves the funds immediately, preventing project leads from accidentally allocating them to catering. If the event is cancelled and the venue refunds the deposit, the encumbrance is cleared and the $3,000 returns to the available budget.
Think of it
Imagine reserving a table at a busy restaurant by putting down a deposit. That table is now off-limits to other walk-in customers, even though you have not ordered your meal yet. Encumbrance accounting works the same way for your business budget.
Formula
Calculation
Available Budget = Total Budget - (Actual Expenses + Encumbrances)
Worked example. Your department has a total budget of $50,000, has spent $20,000 on actual invoices and holds $10,000 in active purchase orders (encumbrances).
Available Budget = $50,000 - ($20,000 + $10,000) = $50,000 - $30,000 = $20,000 remaining.
Liquidation. The supplier's invoice then arrives for $9,600 against a $10,000 purchase order. The $10,000 encumbrance is released and the actual expense of $9,600 is recorded.
Available Budget = $50,000 - ($20,000 + $9,600 + $0) = $20,400.
The extra $400 returns to your available budget because the final cost came in below the amount reserved.Case study
Seen in the real world
Oakwood Community Centre is a fictional organisation with an annual budget of $100,000. Historically, managers struggled with accidental overspending because they only tracked money when bills were paid. Halfway through the year, $52,000 had been paid out, and the centre manager approved a major playground repair estimated at $40,000, issuing a formal purchase order. Unaware that this money was now spoken for, another department lead saw $48,000 of apparently free funds ($100,000 - $52,000) and bought $20,000 of new office furniture. When the playground invoice arrived for $38,000, the centre's total spending reached $52,000 + $38,000 + $20,000 = $110,000.
That was $10,000 over budget, and Oakwood had to scramble for emergency funding. To fix this, Oakwood adopted encumbrance accounting. The following year, when the playground purchase order was issued, $40,000 was instantly locked as an encumbrance, which reduced the available budget to $100,000 - $52,000 - $40,000 = $8,000. When the furniture request came in, the software flagged that only $8,000 remained uncommitted, and the $20,000 order was paused until the budget could be adjusted. This simple shift eliminated end-of-year deficits in this illustrative scenario.
Watch out
Common mistakes
- Treating encumbrances as actual cash payments rather than reserved commitments.
- Failing to release or reverse encumbrance amounts when a supplier cancels an order.
- Forgetting to include encumbrances when calculating available departmental spending limits.
Questions
People also ask
Is encumbrance accounting only for government organisations?
No. While public sector bodies and non-profits use it heavily due to strict regulations, any business wanting tight control over purchase commitments can benefit.
Does an encumbrance reduce my bank account balance?
No. It only reduces your available budget in your internal accounting records. Your actual bank balance remains unchanged until the bill is paid.
What happens to an encumbrance when the invoice arrives?
The encumbrance is reversed or liquidated, and the amount is converted into a standard accounts payable entry for final payment processing.