Encumbrance Definition in Accounting: What It Means and Why It Matters
In the world of accounting, especially governmental and nonprofit accounting, tracking how funds are committed is just as important as tracking how they’re spent. One key concept that helps achieve this control is encumbrance accounting. So what exactly is the encumbrance definition in accounting, and why does it matter?
This guide explains everything you need to know—from the meaning of encumbrances to how they work in real-world accounting systems.
Encumbrance Definition in Accounting
In accounting, an encumbrance is a commitment of funds for a future expenditure. It represents money that is reserved but not yet spent. Commonly used in government, public sector, and nonprofit entities, encumbrances help organizations manage and forecast budgets effectively.
Encumbrances are not actual expenses—they’re planned or expected expenditures, such as purchase orders or contracts, recorded to prevent overspending.
How Encumbrance Accounting Works
Encumbrance accounting involves three main stages:
Encumbrance Created
When a purchase order or contract is issued, the system reserves funds.
Example journal entry:
Dr Encumbrance Account
Cr Budgetary Fund Balance — Reserve for Encumbrance
- Encumbrance Liquidated
When the goods or services are delivered, the encumbrance is reversed. - Expenditure Recorded
The actual expense is then recorded when the invoice is paid.
Why Is Encumbrance Accounting Important?
- Prevents budget overspending
- Improves financial forecasting
- Ensures compliance with funding limits
- Enables proactive budget management
Types of Encumbrances
| Type | Description |
| Commitments | Pending financial obligations (e.g., open purchase orders) |
| Obligations | Legal commitments such as contracts or signed agreements |
| Reservations | Internal designations of funds for anticipated future needs |
Who Uses Encumbrance Accounting?
- Government agencies
- School districts and universities
- Nonprofit organizations
- Large enterprises with complex procurement
Example of Encumbrance in Action
Let’s say a city government has a $500,000 budget for infrastructure. If they approve a $200,000 road repair contract, that amount becomes an encumbrance—reserved in the books—even though no money has been spent yet. This keeps them from accidentally committing more than the remaining $300,000.
Encumbrance vs. Expense vs. Accrual
| Term | Timing | What it Represents |
| Encumbrance | Before transaction occurs | Expected or committed expenditure |
| Expense | After goods/services received | Actual cost incurred |
| Accrual | After services delivered but before payment | Liability for earned expenses |
Advantages of Using Encumbrance Accounting
- Better transparency and control
- Helps ensure funds are available when payments are due
- Assists in budget planning and compliance
- Minimizes surprises in financial reporting
Conclusion
Understanding the encumbrance definition in accounting is essential for organizations that need to tightly manage budgets and financial obligations. By distinguishing between planned and actual expenditures, encumbrance accounting provides a clear financial picture and helps maintain fiscal discipline.
Whether you’re working in public finance, nonprofit budgeting, or large-scale procurement, encumbrance accounting ensures every dollar is accounted for—even before it’s spent.
FAQs
1. What is an encumbrance in accounting?
An encumbrance in accounting refers to funds that have been reserved for a future expenditure. It represents a commitment to spend money but is not yet an actual expense. Common examples include purchase orders, contracts, and commitments.
2. How is encumbrance different from an expense?
Encumbrances are planned or committed costs, while expenses are actual costs incurred after goods or services are received. Encumbrance accounting helps track what funds are expected to be spent, aiding in budget control.
3. Why is encumbrance accounting used?
Encumbrance accounting is used to prevent overspending, improve budget forecasting, and ensure compliance with financial guidelines. It is especially useful in government, education, and nonprofit organizations where fiscal accountability is critical.
4. What is an example of an encumbrance journal entry?
When a purchase order is issued, an encumbrance entry might look like:
- Dr: Encumbrance Account
- Cr: Reserve for Encumbrance
This reserves the budget without recording an actual expense until the transaction is complete.
5. Who typically uses encumbrance accounting?
Encumbrance accounting is commonly used by government agencies, nonprofit organizations, school districts, and large enterprises that need detailed tracking of financial commitments and budget usage.
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