October 08, 2021

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Encumbrance Accounting: Explanation and Example

Encumbrance Accounting: Explanation and Example

Budgeting and Planning

A budget is an itemized plan that includes the income and expenses of a company for a certain period. Most often it is drawn up for a year, but the company itself can increase or decrease the period for which the budget is calculated. For a small business, precise planning several years ahead is impossible, while in a large company, it is impractical to draw up a budget for a month: it will take more time to prepare it than it is worth.

Budgeting seems to be difficult and unnecessary for many entrepreneurs. The main thing is to earn more and figuring out how to spend the income is not that hard. This approach is very popular. Why waste time on boring and incomprehensible numbers? However, it is the planning that allows the company to achieve its goals and grow faster than competitors. Regardless of the approach, budgeting includes the following steps:

  1. Forecast of demand for goods or services of the companyForecasting takes into account the occupied niche, seasonality, sales in previous periods. If on average 1,000 pairs of shoes are sold for $50,000 a month, you should not plan sales for 20,000 pairs. No matter how much you want it.
  2. Accounting for variable costsThe production of 1,000 pairs of shoes requires a certain amount of fabric, accessories, packaging, etc. At this stage, you need to assess what stocks of materials and finished products the company has. Maybe you won’t have to produce anything at all because a batch of 1,000 shoes is already in the warehouse, or you need to buy all the material because stocks are depleted.
  3. Accounting for fixed costsThis includes the rent of a sewing workshop and office, salaries of administrative and production personnel, communication costs, utilities, depreciation, and more. Typically, these costs are approximately the same in each period, so they are called fixed.

The purpose of cost accounting is to optimize the budget: not to spend too much, to plan effectively, and so on. Why is this needed? So that the difference between income and expenses is positive. It is this difference that can be invested into future financial goals. Therefore, if you do not yet know the difference between your income and expenses, then you need to start counting.

Alongside the budget, the company needs to keep a proper record of the items it has promised to its customers or funds it has set aside for a specific purpose. For this goal, the term encumbrance is used in accounting. What does it mean and how is it applied in business processes? Let’s look at this concept a little closer.

Encumbrance Accounting: Explanation and Example

Encumbrance Meaning

The term encumbrance comes from the word “to encumber”. When it comes to encumbrance accounting, it is easier to explain the meaning of this concept using an example. Your company is a distributor of office paper. One of your regular customers ordered 500,000 of these packs of paper. What this means is that your inventory position is encumbered by 500,000 units.

Encumbrances would be the amount that is currently tied up in an actual purchase, meaning the purchase order has been issued. When the purchase order is filled, the amount of encumbrance is reversed in the bookkeeping records. So, with encumbrance accounting, it means that you will record this as if you already sold the items. It is used to record future expenses that a company is sure about.

This helps businesses to have their products always in stock and minimizes possible shortages or overstatements, which will obviously negatively affect all the business processes and, in the end, its profits. Thanks to encumbrance accounting, you will have a better knowledge of where your company is.

In addition, encumbrance can mean that specific funds are restricted to be used only for a specific liability. This allows the company to be confident that it will have enough funds to pay for the expenses it promised and is obligated to pay. For instance, this can be a tax liability, utility bills that a company knows it will have to pay, as well salaries and wages the employees will expect to receive every pay period. Budgeting for these expenses and recording them under encumbrance account is a sure way to keep the government, employees, and other business partners happy and maintain good relationships with everyone.

How It Works

To help you better understand how encumbrance accounting works, we are going to review an example. The city has $50,000 budgeted for trees to be planted in different areas of the city in 2020. In October 2020, the city’s budget had the following data in regards to the trees project:

  • Appropriations – $50,000
  • Encumbrances – 10,000
  • Expenditures – 25,000
  • Vouchers payable – 3,000

One of the organizations has requested if the city can also plant more trees in one of the areas. To determine whether there are enough funds in the budget to meet this request, let’s look at the information a little closer.

We can see that the total amount that was budgeted for the new trees is equal to $50,000. The amount already tied up is equal to $10,000, i.e. trees already ordered but not yet received and planted. So far, the city has already planted $25,000 worth of trees. The voucher (accounts) payable is equal to $3,000, which means that this amount is still outstanding, but the amounts are already accounted for under expenditures.

To calculate whether the city has funds to plant more trees, we would need to subtract the expenditures ($25,000) and encumbrances ($10,000) from the appropriations ($50,000). We would not be subtracting the $3,000 as it is already accounted for in the expenditures. After doing some math, you can tell that the city still has $15,000 available in its budget for trees. If the company had encumbrances of $30,000, it would have overspent its budget and have no more money left for additional trees.

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Author: Charles Lutwidge

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