If you are unsure about installing the Encumbrance Accounting option, review the following questions:

  • Is there usually a lapse in time between placing an order and delivery of products or services?
  • Do you use purchase orders or keep contracts on these products or services?
  • Do you usually incur expenses that you plan to record and pay in the future?
  • Would you like a tool to assist you in figuring out your budget for the next fiscal year? 

If you answered yes to any of these questions, consider installing the option. An encumbrance is a legally binding commitment to eventually pay money for expenditures. Nonprofit organizations largely use encumbrances to prevent overspending and to assist in forecasting cash flow.

When you create contracts or purchase orders, a considerable amount of time may expire. You record these commitments, or encumbrances, on a purchase order specifying the expense account to be used when you creating the invoice for this product or service. Encumbering accounts ensures expenditures do not exceed appropriated amounts. The encumbrance account often has a fund balance reserved just for encumbrances. The reserved fund balance account is not required to use encumbrances in Accounts Payable.

The following journal entry shows the means of preventing over expenditures with the fund balance account reserved for encumbrances.

 DebitCredit
Means of preventing over expendituresFund Balance (Reserved for Encumbrances)Encumbrance Summary Account

The liability encumbrance summary account is a General Ledger account used as a holding place for commitments on products and services until they are incurred. This form of accounting can assist you in reserving a portion of an applicable account appropriation and works like an extension of your operating or general fund.

In Accounts Payable, Default Accounts, you can enter a Purchase Order Encumbrance Account. This account is usually a liability account.

When a product delivery or service is completed and a purchase order is created and completed for amounts encumbered, the encumbrance is reversed and the expenditure recorded for the receipted items. An invoice is created for the expenditures and the following journal entry is made.

 DebitCredit
Purchase Order enteredExpenseEncumbrance
Receipt enteredEncumbranceExpense
Invoice enteredExpenseAccounts Payable Summary

When you record encumbrances, the sum of the balances of the encumbrances and expenditures can be viewed as offsets to the encumbrance summary account. The difference obtained by subtracting the balances of encumbrances and expenditures from the balance of the encumbrance summary account, is the amount you can still encumber. Basically, the Encumbrance Accounting option provides a means to track any items that will become expenditures in the future. You can also use the option to provide budget information for the next fiscal year by running a General Ledger Report in detail on the Encumbrance Account.