What Is an Encumbrance in Accounting: Recording and Year-End

An encumbrance in accounting is a reservation of budget authority set aside the moment a purchase order is approved or a contract is signed. It is not an expense, and it is not a liability. It is a placeholder that reduces how much of an appropriation remains available to spend, so that departments cannot collectively commit more money than they were authorized to spend. The technique belongs mostly to state and local governments and to some non-profits that use fund accounting.

Encumbrance vs. Liability vs. Expense

The difference comes down to timing and legal weight. An encumbrance is created when a commitment is made. At that point no goods have arrived, no services have been performed, and no legal debt exists. The organization is flagging that it intends to spend the funds.

An accounts payable entry appears only after the goods or services have been received and the organization actually owes the vendor money. That is a legal obligation. The encumbrance is a planning tool; the payable is a debt. The National Council on Governmental Accounting made this explicit: encumbrances outstanding at year end “do not constitute expenditures or liabilities.”¹

Expenditures add another wrinkle. In governmental accounting, an expenditure is recognized when a fund liability is incurred. Under the budgetary basis of accounting, though, encumbrances are commonly treated as if they were expenditures for budget-tracking purposes, even though they are never expenditures under GAAP.² The dual treatment makes sense once you notice the two systems are solving different problems. The budget system cares about commitments. The financial statements care about actual transactions.

Why Governments Use Encumbrance Accounting

Governments operate 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.³ Without encumbrance accounting, a department head could issue purchase orders far in excess of the budget, and none of those commitments would show up in the accounting system until the invoices arrived weeks or months later.

Encumbrance accounting closes that gap. The moment a purchase order is approved, the system reduces the available budget by the estimated cost. A manager can see three numbers at any time: what has been spent, what has been committed but not yet spent, and what is truly still available. The formula is straightforward. Appropriation minus expenditures minus outstanding encumbrances equals the unencumbered balance, and that last number is what a manager can still spend.

Commercial businesses generally do not use this technique. A private company recognizes an expense when it is incurred, not when a purchase order is signed, because its financial model is built around matching revenues to the expenses that generated them. Public-sector entities have the opposite priority: showing compliance with spending limits set by law.

Recording an Encumbrance

The journal 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. The entry uses two budgetary control accounts:

Debit: Encumbrances — $10,000
Credit: Budgetary Fund Balance Reserved for Encumbrances — $10,000

These are not balance sheet or income statement accounts. They live inside the budgetary tracking system, and their only job is to reduce the department’s available spending authority. No cash moves, no vendor gets paid, and no liability appears on the books. The entry tells anyone reviewing the budget that $10,000 is spoken for.

Some organizations add a preliminary step called a pre-encumbrance, recorded when a purchase requisition is submitted but before the purchase order is formally approved. Once the purchase order goes through, the pre-encumbrance is reversed and replaced by the actual encumbrance.

Liquidating the Encumbrance When Goods Arrive

When the goods arrive and the vendor sends an invoice, the original encumbrance is removed and replaced with the actual expenditure. It happens in two steps, and the order matters.

First, reverse the original encumbrance at the estimated amount. Using the $10,000 example:

Debit: Budgetary Fund Balance Reserved for Encumbrances — $10,000
Credit: Encumbrances — $10,000

Second, record the actual expenditure and liability at the invoiced amount. If the invoice arrives at $10,150:

Debit: Expenditures — $10,150
Credit: Accounts Payable — $10,150

The reversal always uses the original estimated amount. The expenditure entry uses the actual invoiced amount. The $150 gap between estimate and reality automatically adjusts the unencumbered balance. If the invoice had come in at $9,900, the $100 surplus would flow back into the available budget instead.

Partial shipments work the same way at a smaller scale. If a $10,000 order is half-filled with a $5,000 invoice, the organization reverses $5,000 of the encumbrance, records a $5,000 expenditure, and leaves the remaining $5,000 encumbered until the rest of the order arrives or the order is cancelled.

What Happens at Year End

What to do with an open purchase order when the fiscal year ends is one of the more consequential questions in governmental budgeting. The answer depends on the jurisdiction’s legal framework, and there are two main scenarios.

In many jurisdictions, unencumbered appropriations lapse at year end but encumbered appropriations carry forward. Outstanding encumbrances are reported as reservations of fund balance, preserving the spending authority into the next fiscal year so the organization can pay the vendor when the goods eventually arrive.¹

In other jurisdictions, all appropriations lapse at year end, even encumbered ones. When 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 those commitments.¹ The vendor still gets paid; the accounting path is different because the spending authority has to be reauthorized.

How Encumbrances Appear in Financial Statements

You will not find a line item labeled “encumbrances” on a government balance sheet. It was not always so. Before GASB Statement No. 54 took effect, governments reported a separate “Reserved for Encumbrances” category within fund balance. GASB 54 eliminated the old reserved and unreserved classification and replaced it with five categories based on how constrained the funds are: nonspendable, restricted, committed, assigned, and unassigned.⁴

Encumbered amounts are 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 encumbered amounts were otherwise unassigned, they get classified as committed or assigned depending on how the government encumbered them.⁴ The reasoning is that an encumbrance does not add any constraint beyond what the committed or assigned classification already communicates.

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 stay in use for day-to-day budget management. They simply do not surface in the external financial reports the way they once did.

What Kinds of Commitments Trigger an Encumbrance

Purchase orders for supplies and equipment are the most common trigger, but they are not the only one. Any formal commitment of budgeted funds can create an encumbrance. Common examples include:

Contracts for services, such as a signed agreement with a consulting firm, IT vendor, or construction contractor, encumbered for the contract value.
Salary commitments, where some governments encumber estimated payroll costs for positions that have been authorized and filled.
Grant sub-awards, where a pass-through of grant funds to a sub-recipient is encumbered against the grant appropriation.
Blanket or standing purchase orders for recurring purchases from a single vendor, such as monthly fuel deliveries, encumbered for the estimated annual total at the start of the fiscal year.

The common thread is a formal commitment tied to a specific dollar estimate. Informal plans do not create encumbrances. The commitment has to be documented through a purchase order, an executed contract, or a similar instrument before the entry is appropriate. 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.”¹

1
Governmental Accounting Standards Board. NCGA Statement 1 – Governmental Accounting and Financial Reporting Principles
2
Government Finance Officers Association. Basis of Accounting versus Budgetary Basis
3
Governmental Accounting Standards Board. GASB Codification 1700 – The Budget and Budgetary Accounting
4
Governmental Accounting Standards Board. Statement No. 54 – Fund Balance Reporting and Governmental Fund Type Definitions