To reduce erratic expenditure and prevent overspending, most companies use budgetary controls. In encumbrance accounting, there are many types of accounting in which the estimating expenses are involved to plan budgets and avoid overspending through accountants who specialize in it. Here, it is useful to clearly understand encumbrance accounting at one cost when you work as an accountant or want to plan your organization’s budget effectively. As a part of the budgeting process, encumbrance in accounting can be recorded on financial statements.
In this blog, we’ll guide you through the process of “What is an Encumbrance in Accounting?”, its uses, its involved steps, and other things.
What is an Encumbrance Accounting?
Encumbrance Accounting is a budget control method that is used to ensure that the money is set aside for future financial expenses and commitments. In both government accounting and non-profit accounting, these types of budgetary control are required till future expenses need to be accounted properly and makes you sure that the money is available. For better management of upcoming commitments and expenditures, both privately and publicly owned businesses can use encumbrance in accounting.
Why is Encumbrance Important in Accounting?
Encumbrance is important in accounting because it serves as a type of reminder that has been committed to a budget manager to preserve enough funds to make payments for goods and services when they are eventually delivered. Typically, the encumbrance will automatically clear the payment process for the goods or services. Occasionally, the final expense leaves an outstanding encumbrance that shows against your budget, which is not as large as the anticipated commitment.
What are the Uses of Encumbrance in Accounting?
In the financial management of an organization, Encumbrance accounting plays a crucial role, especially with complex budgeting and financial commitment. In various sectors, its uses extend across organizations, like government, education, non-profits, and business.
Budgetary Control
Encumbrance in accounting allows against the approved budget to track the commitments of their financial management. And also helps you to ensure that the resources which are already planned are aligned with the expenditures.
Resource Allocation and Financial Planning
By making a record of encumbrance in accounting, more effective plans can be created by organizations for their future expense. The funds can be allocated for anticipated purchases, essential projects, or contracts in advance, through which cash flow forecasting and resource allocation can be aided.
Compliance
Mostly in government agencies and educational institutions, compliance is primarily with the regulations of the budget and legal requirements. The encumbrance accounting for government organizations helps you with these regulations to ensure you about budget allocations. In the agreement, the budget allocations are used with the help of promoting transparency and accountability.
Financial Transparency
To enhance the financial transparency through an encumbrance in accounting, there is a clear record has been provided for outstanding obligations. You can easily access the financial responsibility and some information about committed funds by taking help from stakeholders, like government agencies, shareholders, and donors.
Preventing the Overruns of the Budget
Organizations can easily monitor their financial commitments through tracking the encumbrance and adjusting spending if necessary. When you need a proactive approach, it ensures that it is available in your financial resources through which you can prevent budget overruns.
Audit Preparedness
In an accurate encumbrance accounting, it has recorded streamlined financial audits while simplifying the process of audit with commitments and budgetary plans. In one line, their financial activities can be demonstrated by organizations.
Project and Risk Management
In project management, accounting of encumbrances is aid in business and project-based organizations. For a specific project or contract, funds can be reserved to ensure the budgets of projects are complied with the sufficient resources that are available. For contractual obligations, this helps you to migrate your financial risks by making sure that the funds are allocated in an appropriate location.
Steps Involved in Encumbrance Accounting
In the general ledger, an encumbrance is noted when you purchase some goods or services that are billed later. In accounts payable and procurement functions, the encumbrance account is an important factor. Here, we’ve discussed the steps that are involved during the process of encumbrance in accounting is interconnected with the purchase-to-pay tax of a company, as in the following ways:
Pre-Encumbrance
The encumbrance in the accounting process begins when the company’s identity needs to purchase any goods or services on credit. At this point, a legal obligation has not been established to pay vendors, but there is an acknowledgement of future expenses which need to be paid in the encumbrance process. With the help of documents like purchase requisitions, the pre-encumbrance is noted, and an identity is needed, but it is still not legally bound.
Encumbrance
The payments become legally due when a vendor has been selected for a purchase order that has already been set up properly with the vendor. Those funds allocated for the purchase are not allowed to be used for any other purposes, nor can the companies take them back from the encumbrance account.
Expenditure
In the general ledger, the funds are allocated to accounts payable when the goods or services are delivered by the vendors; at that time, an invoice has been sent, and by the same account, the encumbrance account is reduced. If the liabilities no longer exist or are carried during the year-end closing, the encumbrance funds are removed. Under the reserved fund balances, the encumbrances are recorded in the balance sheet.
Conclusion
At the end of the conclusion, we conclude that encumbrance in accounting is one type of process which is a very important component of effective financial management. An organization can ensure the proper allocation of funds and prevent overspending by recording future payment commitments accurately and managing the budget control. It can also enhance their financial reports, analysis, and cash flow predictions by implementing an efficient encumbrance accounting system. If still any problem, you can contact our tech support.