The FASB gives guidance for reporting restricted cash on the balance sheet and in cash flow statements. Regularly monitor and adjust the encumbrances recorded in your accounting system. This involves updating the encumbrance amounts as commitments are fulfilled or modified.
Encumbrance accounting sets aside specific assets to pay anticipated liabilities. For example, a company may reserve a sum of cash to settle up its accounts payable. The presence of an encumbrance can give the illusion that there are more available encumbrance accounting funds inside an account than what is actually free for use. The money that has been set aside cannot be used for any other expenditures or transactions. Encumbrance accounting, therefore, ensures that a business does not overspend its budget.
Encumbrance
By reserving funds for future liabilities, such as payroll and taxes, organizations can ensure that they have the necessary funds available when needed. This allows for better expenditure control and prevents overspending, ultimately leading to improved financial stability. Its multifaceted uses contribute to responsible financial management and informed decision-making. Organizations use budgetary controls to minimize maverick spending and avoid overspending. It allows government entities, nonprofits, and some businesses to more effectively monitor and control how much they spend.
Any encumbrance funds are not part of the actual funds ledger balance, because payments haven’t been processed. Once a vendor is paid, the encumbrance is lifted and the funds appear in the actual funds balance rather than the encumbrance balance. An encumbrance can impact the transferability of the property and restrict its free use until the encumbrance is lifted.
Why is encumbrance accounting needed?
This type of accounting also helps detect fraud, prevent rampant spending, and increases budget control. Your company has received the goods or services that were initially ordered and now must pay back the vendor’s invoice. Money from the encumbrance account is moved into the appropriate account to pay the invoice, and accounts payable handles the vendor payment. 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. Once the encumbrance is approved, the funds are no longer available for use in other transactions.
This is especially valuable for long-term financial planning and decision-making. This systematic approach helps organizations effectively manage their budgets, comply with regulations, and maintain financial transparency. In business, it is essential to have a clear understanding of all financial matters, including encumbrance accounting.
AccountingTools
Encumbrance accounting helps companies track their budget and catch overspending in any category. A lien is a type of security interest, an encumbrance that affects the title to a property. It gives a creditor the right to seize the property as collateral for an unmet obligation, usually an unpaid debt. The creditor can then sell the property to recoup at least a portion of their loan. When an organization creates a new purchase order or adds a new line item to an existing purchase order, the new items are encumbered to the journal. An entry is made in the journal with a debit to the encumbrance account and transferred to the general ledger.
