An encumbrance in accounting is a reservation of budget authority, not an expense and not a liability. The entry is made the moment a government or nonprofit makes a formal commitment to spend, such as approving a purchase order or signing a contract, and it reduces the available budget before any goods arrive or any money changes hands. The purpose is simple: keep departments from collectively committing more than the legislature or board actually authorized.
How an Encumbrance Differs From a Liability or an Expense
The confusion usually starts here, because an encumbrance, a payable, and an expenditure all involve money the organization expects to part with. The differences are timing and legal weight.
An encumbrance exists at the commitment stage. A purchase order goes out, and the system flags the estimated amount as spoken for. Nothing has been delivered, no services performed, no debt created. The National Council on Governmental Accounting put it plainly: encumbrances outstanding at year end “do not constitute expenditures or liabilities.”1Governmental Accounting Standards Board. NCGA Statement 1 – Governmental Accounting and Financial Reporting Principles
An accounts payable entry comes later, once the goods or services have actually been received and the vendor is owed real money. That is a legal debt. An expenditure, in governmental accounting, is recognized when the fund liability is incurred. Encumbrances are often treated as if they were expenditures for budget-tracking purposes under the budgetary basis of accounting, even though they are never classified as expenditures under GAAP.2Government Finance Officers Association. Basis of Accounting versus Budgetary Basis Two parallel systems, two different jobs. The budget system cares about commitments. The financial statements care about actual transactions.
Why Governments Use Encumbrance Accounting
Governments spend under legally appropriated budgets. A city council or state legislature authorizes specific dollar amounts for specific purposes, and those amounts are ceilings that cannot legally be exceeded without further authorization.3Governmental Accounting Standards Board. GASB Codification 1700 – The Budget and Budgetary Accounting Without a mechanism to track commitments as they are made, a department head could issue purchase orders totaling far more than the appropriation allows, because none of those commitments would appear in the accounting system until the invoices arrived weeks or months later.
The encumbrance closes that gap. The approved purchase order reduces available budget immediately. A manager can see three numbers at any moment: what has been spent, what has been committed but not yet spent, and what remains truly available. The arithmetic: appropriation minus expenditures minus outstanding encumbrances equals the unencumbered balance. That last figure is what can still be committed.
This is a feature of fund accounting, the reporting system used by state and local governments and many nonprofits. Private companies generally do not use encumbrance accounting; their reporting is built around matching revenues with the expenses incurred to earn them. Public-sector entities face a different priority: proving compliance with spending limits set by law.
Recording an Encumbrance
The entry is triggered when a formal commitment is created, most often an approved purchase order. Say a city department issues a purchase order for $10,000 of office equipment. Two budgetary control accounts move:
- Debit: Encumbrances $10,000
- Credit: Budgetary Fund Balance Reserved for Encumbrances $10,000
Neither account sits on the balance sheet or the income statement. They exist inside the budgetary tracking system to reduce the department’s available spending authority. No cash moves. No vendor is paid. No liability is booked. The entry simply records that $10,000 is spoken for.
Some organizations add an earlier step called a pre-encumbrance, recorded when a purchase requisition is submitted but before the purchase order is formally approved. Once the purchase order is approved, the pre-encumbrance is reversed and the actual encumbrance takes its place.
Liquidating the Encumbrance When the Invoice Arrives
When the goods arrive and the vendor invoices, the original encumbrance has to come off the books and be replaced by the actual expenditure. This takes two entries, and the order matters.
First, reverse the original encumbrance at the estimated amount:
- Debit: Budgetary Fund Balance Reserved for Encumbrances $10,000
- Credit: Encumbrances $10,000
Second, record the actual expenditure and the liability at the invoiced amount. If the invoice came in at $10,150:
- Debit: Expenditures $10,150
- Credit: Accounts Payable $10,150
The reversal always uses the original estimate. The expenditure entry uses the actual invoiced figure. The $150 difference adjusts the unencumbered balance automatically. Had the invoice come in at $9,900, the $100 surplus would flow back into the available budget.
Partial Deliveries
Not every order arrives in one shipment. When a vendor delivers only part of an order, only the portion matching the goods received is reversed and recorded as an expenditure. The rest stays encumbered until the next shipment arrives or the order is cancelled. A $10,000 purchase order half-filled with a $5,000 invoice means $5,000 of the encumbrance is reversed, a $5,000 expenditure is booked, and $5,000 remains reserved against the budget. Without this mechanism, partial deliveries on large contracts would quickly obscure how much budget authority is actually left.
What Creates an Encumbrance
Purchase orders for supplies and equipment are the most common trigger, but any formal commitment of budgeted funds can create one:
- Contracts for services, including consulting, IT, and construction agreements, encumber the contract value when signed.
- Some governments encumber estimated payroll for positions that have been authorized and filled.
- Grant sub-awards encumber the appropriation when a government passes funds through to a sub-recipient.
- Blanket or standing purchase orders for recurring purchases, such as monthly fuel deliveries, may be encumbered for the estimated annual total at the start of the fiscal year.
What ties these together is a documented commitment attached to a specific dollar estimate. Informal plans to spend do not qualify. NCGA Statement 1 directs that encumbrance accounting “should be utilized to the extent necessary to assure effective budgetary control and accountability and to facilitate effective cash planning and control.”1Governmental Accounting Standards Board. NCGA Statement 1 – Governmental Accounting and Financial Reporting Principles
What Happens to Open Encumbrances at Year End
This is one of the more consequential questions in governmental budgeting, and the answer depends on the jurisdiction’s legal framework. Two scenarios cover most of it.
In many jurisdictions, unencumbered appropriations lapse at year end but encumbered appropriations carry forward. The outstanding encumbrances are reported as reservations of fund balance, which preserves the spending authority into the next fiscal year so the vendor can be paid when the goods eventually arrive.1Governmental Accounting Standards Board. NCGA Statement 1 – Governmental Accounting and Financial Reporting Principles
In other jurisdictions, all appropriations lapse at year end, encumbered ones included. If the government still intends to honor those outstanding contracts, the encumbrances should be disclosed in the notes to the financial statements, and the following year’s budget must include new appropriations to cover the commitments.1Governmental Accounting Standards Board. NCGA Statement 1 – Governmental Accounting and Financial Reporting Principles The vendor still gets paid, but the spending authority has to be reauthorized.
Where Encumbrances Appear in Financial Statements
If you are reading a government’s financial statements, you will not find a line labeled “Encumbrances” on the balance sheet. That changed with GASB Statement No. 54, which eliminated the old reserved/unreserved classification and replaced it with five categories based on how constrained the funds are: nonspendable, restricted, committed, assigned, and unassigned.4Governmental Accounting Standards Board. Statement No. 54 – Fund Balance Reporting and Governmental Fund Type Definitions
Encumbered amounts are now folded into whichever classification already applies. If funds were already restricted or committed for a specific purpose, the encumbrance does not create a separate display. If the amounts were otherwise unassigned, they are classified as committed or assigned depending on the process the government used to encumber them.4Governmental Accounting Standards Board. Statement No. 54 – Fund Balance Reporting and Governmental Fund Type Definitions An encumbrance, in GASB’s view, does not represent any additional constraint beyond what those classifications already communicate.
Significant outstanding encumbrances still have to be disclosed, but the disclosure sits in the notes to the financial statements alongside other commitments rather than on the face of the balance sheet. The internal budgetary accounts remain in use for day-to-day budget management; they just do not carry through to external financial reports with the same visibility they once had.