Encumbrance Accounting | Governmental Accounting | Lapse At year End | CPA Exam BAR

In this video, I explain the encumbrance accounting in governmental accounting using an example.
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An "encumbrance account" is a type of accounting record used in accrual accounting and budgeting to represent commitments for future expenses. The concept of an encumbrance is used primarily in governmental and non-profit accounting. Here's a basic breakdown of what it entails:

Definition: An encumbrance is money that has been set aside for a specific future expense. This could be for contracts that have been signed but not yet executed, or for goods or services that have been ordered but not yet received.

Purpose: The main purpose of an encumbrance account is to avoid overspending. By recording future expenses, an organization can keep track of its available funds more accurately. This is particularly important in environments where budgets are strict and must be adhered to, such as in government or grant-funded organizations.

Process: When an encumbrance is recorded, the amount of the commitment is reserved in the encumbrance account. This reduces the available budget. When the goods or services are received, and the bill is paid, the encumbrance is reversed, and the actual expense is recorded in the appropriate expense account.

Impact on Financial Statements: Encumbrances do not appear on the standard financial statements like the balance sheet or income statement. Instead, they are often reported in the notes to the financial statements or in supplementary schedules, especially in governmental accounting.

Example: For instance, a city government may set aside funds for a road construction project in an encumbrance account. Even though the money has not yet been spent, recording it as an encumbrance ensures that the city does not allocate these funds for another project.

Accounting Treatment: In accounting terms, when an encumbrance is recorded, a debit is made to an encumbrance account and a corresponding credit to a budgetary fund balance or reserve account. When the actual expense occurs, the encumbrance account is credited (reversing the original entry), and the actual expense account is debited.

Importance in Budgeting: Encumbrance accounting is crucial for effective budget management, particularly in public sector and non-profit organizations. It helps these entities maintain fiscal discipline and ensure that funds are available for committed expenses.

This accounting practice provides a more comprehensive view of an organization's financial commitments and available resources, aiding in more informed financial decision-making and budgeting.


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