What Is an Encumbrance and Why Does It Matter?
An encumbrance in accounting is the formal reservation of funds within a budget for a specific future expenditure. When a department issues a purchase order, signs a contract, or makes any other commitment to spend money, an encumbrance is recorded to earmark those budget dollars so they cannot be spent on anything else. The funds are not yet spent -- no cash has changed hands, no invoice has been received -- but they are effectively "spoken for" within the budget.
The concept is deceptively simple, but its implications for financial management are profound. Without encumbrance accounting, a budget manager can look at their remaining budget balance, see $50,000 available, and authorize a new purchase -- not realizing that $40,000 of that balance is already committed to purchase orders that have not yet been invoiced. With encumbrance accounting, the budget report shows the $50,000 budget balance, minus $40,000 in outstanding encumbrances, leaving only $10,000 truly available for new commitments. That distinction -- between what is technically unspent and what is actually available -- is the entire purpose of encumbrance accounting.
At Northstar Financial, we encounter encumbrance accounting most frequently in our work with government contractors, grant-funded organizations, and nonprofit entities that must demonstrate compliance with specific funding restrictions. But the underlying principle -- tracking commitments against a fixed budget before the money is actually spent -- is valuable for any organization that operates within defined spending limits, which in practice means every well-run business.
How Does an Encumbrance Differ from an Expense?
This is the question that trips up most people who are encountering encumbrance accounting for the first time, and the distinction is critical for understanding how the system works.
An expense is recorded when an economic event has occurred -- goods have been received, services have been rendered, or a liability has been incurred. Under both GAAP and governmental accounting standards, an expense (or expenditure, in governmental terminology) represents a completed transaction. The organization has received something of value and has either paid for it or is obligated to pay for it. The expense reduces both the budget balance and the fund balance (or retained earnings in private-sector accounting).
An encumbrance is recorded when a commitment has been made but the transaction is not yet complete. A purchase order has been issued, but the goods have not been received. A contract has been signed, but the services have not been performed. The organization has obligated itself to spend the money, but the economic event that would trigger expense recognition has not yet occurred. The encumbrance reduces the available budget but does not reduce the fund balance or appear on the statement of revenues, expenditures, and changes in fund balance.
The practical difference is timing and certainty. An expense is a done deal -- the money is spent or owed. An encumbrance is a commitment that will likely become an expense but has not yet. Purchase orders can be canceled. Contracts can be modified. The actual cost of goods received may differ from the purchase order amount. An encumbrance captures the estimated future obligation, and when the actual expense is recorded, the encumbrance is reversed.
Think of it this way. If your department has a $200,000 annual budget for office supplies, and in January you issue a purchase order for $15,000 in supplies, the encumbrance accounting entries reduce your available budget by $15,000 immediately -- even though the supplies have not arrived and you have not paid anything. Your budget report shows $200,000 total budget, minus $15,000 encumbered, leaving $185,000 available for new commitments. When the supplies arrive and you receive the invoice, the encumbrance is reversed and the actual expense is recorded. If the invoice comes in at $14,200 (less than the PO amount), the $800 difference is released back to available budget.
What Are the Three Types of Encumbrances?
Most encumbrance accounting systems recognize three stages of commitment, each representing a different level of certainty about the future expenditure.
Pre-encumbrances (also called requisitions or commitment encumbrances) represent the earliest stage of the commitment process. A pre-encumbrance is recorded when a department submits a purchase requisition -- a formal request to spend money that has not yet been approved by purchasing or management. Pre-encumbrances provide the earliest possible visibility into future spending intentions, but they carry the lowest level of certainty because the requisition may be denied, modified, or abandoned. Not all organizations track pre-encumbrances; many skip directly to encumbrances when the purchase order is issued.
Encumbrances (sometimes called commitments or obligations) represent the middle stage and are the most commonly tracked type. An encumbrance is recorded when a purchase order is issued to a vendor, a contract is executed, or any other binding commitment to spend funds is made. At this point, the organization has made a formal promise to pay, and while the order can still be canceled or modified, the commitment is substantially more certain than a requisition. This is the stage that most budget reports focus on, and it is the stage that matters most for budget control.
Expenditures (or actual expenses) represent the final stage -- the goods or services have been received, the invoice has been approved, and the payment is either made or owed. When the expenditure is recorded, the corresponding encumbrance is reversed because the commitment has been fulfilled. The budget report now shows the expenditure as actual spending rather than an encumbrance.
The three-stage system creates a complete picture of budget utilization at any point in time. A budget report for a department might show: $500,000 total budget, $50,000 in pre-encumbrances (requisitions submitted but not yet approved), $120,000 in encumbrances (purchase orders issued but not yet received), $280,000 in actual expenditures, and $50,000 in available (unencumbered) balance. This level of detail allows budget managers to make informed spending decisions and allows finance officers to forecast cash needs with greater accuracy.
How Do You Record Encumbrance Journal Entries?
The journal entries for encumbrance accounting follow a specific pattern that differs from standard accrual accounting entries. In governmental accounting, encumbrances are recorded using budgetary accounts that exist outside the normal asset-liability-revenue-expense framework.
When the purchase order is issued (encumbrance is created), the entry is a debit to Encumbrances and a credit to Reserve for Encumbrances (also called Budgetary Fund Balance Reserved for Encumbrances). Both of these are budgetary accounts. For example, if a department issues a purchase order for $25,000 in computer equipment, the entry is: debit Encumbrances $25,000, credit Reserve for Encumbrances $25,000. This entry does not affect the general ledger accounts that flow to the financial statements -- it only affects the budgetary accounts that appear on budget-to-actual reports.
When the goods are received and the invoice is approved (encumbrance is liquidated and expenditure is recorded), two entries are required. First, the original encumbrance is reversed: debit Reserve for Encumbrances $25,000, credit Encumbrances $25,000. Second, the actual expenditure is recorded: debit Expenditures $24,500 (the actual invoice amount), credit Accounts Payable (or Vouchers Payable) $24,500. Notice that the actual expenditure ($24,500) is less than the original encumbrance ($25,000). The $500 difference is released back to the available budget.
When a purchase order is canceled or partially canceled, the encumbrance reversal is recorded without a corresponding expenditure entry. If the $25,000 PO is canceled entirely: debit Reserve for Encumbrances $25,000, credit Encumbrances $25,000. The full $25,000 is released back to available budget.
At fiscal year-end, organizations must decide how to handle outstanding encumbrances -- purchase orders that were issued before year-end but not yet fulfilled. There are two common approaches. The first is to lapse the encumbrances, which means canceling them and requiring the department to re-encumber the amounts in the new fiscal year's budget. The second is to carry forward the encumbrances, which means reserving fund balance from the prior year to cover the outstanding commitments and recognizing those encumbrances as a charge against the prior year's budget. The approach used depends on the organization's policies and applicable regulations. Most state and local governments carry forward encumbrances for significant commitments (contracts, capital projects) and lapse encumbrances for routine purchases.
Who Uses Encumbrance Accounting?
Encumbrance accounting is primarily associated with the public sector, but its application extends beyond government.
State and local governments are the most extensive users of encumbrance accounting. The Governmental Accounting Standards Board (GASB) establishes accounting standards for state and local governments in the United States, and GASB standards specifically address encumbrance accounting within the framework of governmental fund accounting. Under GASB, encumbrances are not liabilities (because the goods or services have not been received), and they are not expenses (because the economic event has not occurred). They are budgetary commitments that are disclosed in the financial statements as reservations of fund balance. Most state and local government accounting policies require encumbrance accounting for all departmental budgets, and budget reports that show the encumbered and unencumbered balances are the primary tool for budget management.
Federal government agencies use a similar but more formalized system of obligations tracking. Under federal accounting standards (established by the Federal Accounting Standards Advisory Board, or FASAB), obligations are recorded when a binding agreement to spend funds is made, and the obligation reduces the agency's available appropriation authority. The concept is functionally identical to encumbrance accounting -- funds are committed before they are spent -- but the terminology and regulatory framework differ from state and local government practice.
Nonprofit organizations, particularly those that receive government grants or manage restricted funds, frequently use encumbrance accounting to demonstrate that grant funds are being spent according to the grant agreement. A nonprofit that receives a $500,000 federal grant with specific spending categories (personnel, equipment, travel, indirect costs) needs to track not only what has been spent in each category but what has been committed. Without encumbrance accounting, a program manager might authorize a $50,000 equipment purchase not realizing that $45,000 in equipment has already been ordered, pushing total equipment spending over the budgeted amount. Grant compliance audits (such as those conducted under the Uniform Guidance, 2 CFR Part 200) specifically examine whether the organization maintained adequate budgetary controls, and encumbrance accounting is one of the primary mechanisms for demonstrating those controls.
Private-sector companies rarely use formal encumbrance accounting in the way governments and nonprofits do, but the concept has direct analogs. A construction company that tracks committed costs on a project -- contracts and purchase orders that have been issued but not yet invoiced -- is performing a version of encumbrance accounting. A SaaS company that tracks committed spend against its annual IT budget is doing the same thing, even if the terminology and the journal entries differ. Any organization that needs to answer the question "how much of our budget is actually available for new commitments" is engaging with the fundamental problem that encumbrance accounting solves.
How Does Encumbrance Accounting Support Budgetary Control?
Budgetary control -- the process of ensuring that actual spending does not exceed authorized spending levels -- is the primary reason encumbrance accounting exists, and understanding this purpose clarifies how the system should be implemented.
The budget execution cycle in a well-controlled organization works as follows. The legislative body or board approves a budget that authorizes a specific amount of spending for each department or program. Throughout the fiscal year, departments make spending commitments (purchase orders, contracts) that are recorded as encumbrances, reducing the available budget. Before any new commitment is authorized, the available budget balance (total budget minus existing encumbrances minus actual expenditures) is checked to ensure sufficient funds exist. If the available balance is insufficient, the commitment cannot be made without a budget amendment -- a formal process requiring approval from the legislative body or board.
This is fundamentally a preventive control, not a detective one. The goal is to prevent overspending before it happens, not to discover it after the fact. When a department head submits a purchase order for $30,000 and the accounting system shows only $25,000 in available (unencumbered) budget, the system blocks the purchase order from being processed. The department head must either reduce the purchase order amount, identify another line item with available budget to transfer funds from, or request a formal budget amendment. This process happens before the commitment is made, not after the invoice arrives and the budget is already overdrawn.
Without encumbrance accounting, budget control relies solely on comparing actual expenditures to the budget. This approach has a fundamental timing flaw: by the time an expenditure is recorded (goods received, invoice processed), the money is already committed and the budget overage cannot be prevented -- only detected. In the government sector, this is particularly problematic because budget authority is a legal constraint, not just a management tool. A department that overspends its appropriation may be violating state law, and the officials responsible can face legal consequences.
The reports generated by encumbrance accounting provide the information that budget managers need to make real-time spending decisions. A standard encumbrance status report shows, for each budget line item, the original budget amount, any amendments, the total amended budget, year-to-date encumbrances, year-to-date expenditures, and the unencumbered balance. Some organizations add columns for pre-encumbrances and for the percentage of budget utilized (encumbrances plus expenditures as a percentage of total budget). These reports are typically generated monthly or on demand, and they are the primary management tool for department heads, finance officers, and elected officials.
What Are Common Mistakes in Encumbrance Accounting?
Even organizations that have used encumbrance accounting for years make mistakes that undermine the system's effectiveness. Understanding these common failures helps you build a more robust process.
Failing to encumber all commitments is the most fundamental error. If purchase orders are issued outside the accounting system -- via email, phone, or informal agreements -- and no encumbrance is recorded, the budget reports understate committed spending and overstate available funds. The entire premise of encumbrance accounting breaks down if commitments are not captured comprehensively. This is particularly common with professional services contracts, where a verbal authorization to begin work may precede the formal contract by weeks or months.
Not reversing encumbrances when expenditures are recorded creates double-counting. If a $10,000 encumbrance remains on the books after the $10,000 invoice is recorded as an expenditure, the budget report shows $20,000 in committed and spent funds when the actual obligation is only $10,000. This error makes the budget appear more constrained than it actually is, potentially causing departments to forgo legitimate purchases or request unnecessary budget amendments.
Using encumbrances as a year-end "parking" strategy is a misuse of the system that auditors watch for. Some departments, facing the prospect of losing unspent budget authority at fiscal year-end (a "use it or lose it" budget policy), issue purchase orders in the final weeks of the fiscal year for goods or services they do not actually need, creating encumbrances that carry forward budget authority into the next fiscal year. External auditors are trained to scrutinize year-end encumbrances for legitimacy, and findings of artificial encumbrances can result in audit findings, management letter comments, and reputational damage.
Inadequate training for budget managers on how to read and use encumbrance reports leads to the system being ignored rather than relied upon. If department heads do not understand the difference between the unencumbered balance and the total budget, or if they do not check available balances before authorizing purchases, the encumbrance system exists on paper but does not function as a control. Regular training -- not just during onboarding, but annually as a refresher -- is essential for the system to serve its purpose.
How Do You Implement Encumbrance Accounting in Your Organization?
If your organization does not currently use encumbrance accounting and you want to implement it, the process involves both system configuration and process change.
Software capabilities are the starting point. Most governmental accounting software platforms (Tyler Technologies/Munis, SAP Government, Oracle PeopleSoft) have built-in encumbrance accounting modules. For organizations using general-purpose accounting software (QuickBooks, Sage, NetSuite), encumbrance tracking may require custom configuration, add-on modules, or parallel tracking in a spreadsheet-based system. At minimum, your system needs to be able to record encumbrance transactions (separate from expense transactions), reduce available budget when encumbrances are created, reverse encumbrances when the corresponding expenditure is recorded, and generate budget reports that show encumbered, expended, and available balances by budget line item.
Process design determines whether the system actually controls spending. The critical process is the "budget check" -- the step where a new commitment (purchase order or contract) is verified against the available budget before it is approved. This check can be automated (the system blocks the PO if insufficient budget exists) or manual (a budget analyst reviews each PO against available funds). Automated checks are far more reliable because they cannot be bypassed by oversight or time pressure, but they require properly configured software.
Change management is often the hardest part. Departments accustomed to spending without pre-commitment tracking will resist the additional step of creating purchase orders and waiting for budget verification. The finance team needs to communicate clearly why encumbrance accounting is being implemented (to prevent overspending and improve financial reporting), provide hands-on training for every budget manager and purchasing staff member, and establish a responsive process for handling exceptions and budget transfers so that the system does not become a bureaucratic bottleneck.
At Northstar Financial, we have helped organizations across the government, nonprofit, and private sectors implement and improve their budgetary control processes, including encumbrance accounting systems. Whether you are implementing encumbrance accounting for the first time, cleaning up a system that is not working effectively, or preparing for an audit that will evaluate your budgetary controls, our team has the experience to guide you through the process. Schedule a strategy call to discuss your specific situation.