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The term encumbrance is crucial in accounting. However, it has applications outside finance as well. Before discussing its accounting, it is crucial to define what it means.
What is Encumbrance?
An encumbrance refers to a claim or liability that affects the ownership or value of an asset. In real estate, it commonly includes financial claims like mortgages or liens, or legal restrictions such as easements that impact the property’s transferability or usability. For example, a mortgage on a house represents an encumbrance because it encumbers the property with a financial obligation that must be resolved before selling the property.
In accounting and budgeting, an encumbrance is a reserved amount of funds set aside for specific future expenses or obligations, ensuring that the necessary money is available when needed. This practice helps organizations manage their financial resources effectively and plan for anticipated costs. In legal contexts, encumbrances can include restrictions or burdens that limit the use or transferability of an asset, such as rights of way or property covenants, affecting how the asset can be utilized or transferred.
How does Encumbrance work?
Encumbrances are claims or restrictions that affect the value and usability of assets, operating in various contexts to impose limitations or obligations. In real estate, encumbrances such as mortgages or liens create financial claims against the property. A mortgage encumbrance means the property cannot be sold or transferred until the debt is cleared. Similarly, easements grant others specific rights to use part of the property, which can restrict the owner’s control over that section.
In accounting and budgeting, encumbrances involve setting aside funds for future expenses. When an organization encumbers funds, it records a commitment to allocate a specific amount for anticipated costs, ensuring these funds are reserved and available when needed. This practice helps manage financial resources and prevent overspending by accounting for future obligations in advance.
Legally, encumbrances impose restrictions on the use or transfer of assets. For example, property covenants can limit how a property can be developed or used, potentially affecting its market value and the owner’s ability to modify or sell it. These restrictions play a role in managing how assets are utilized and transferred, balancing between safeguarding interests and enabling asset management.
What is the accounting for Encumbrance?
In accounting, encumbrance accounting involves reserving funds for future expenses to ensure budget control. When a future expense is anticipated, an encumbrance is recorded by debiting an encumbrance account and crediting a budgetary account. This reservation of funds helps organizations manage their budgets by clearly marking funds set aside for specific obligations, preventing overspending.
As expenses are incurred or commitments are adjusted, the encumbrance is updated accordingly. The encumbrance account gets debited to reduce the reserved amount, and the cost is recorded separately. If the commitment is no longer needed or is reduced, adjustments are made to reflect the changes. This process ensures that budgetary resources are accurately tracked and managed, maintaining financial control and accountability.
What is the journal entry for Encumbrance?
As mentioned, when a company anticipates a future expense, it records encumbrance. This entry will debit the encumbrance account and credit a budgetary account. Mostly, this journal is internal and doesn’t impact the financial statements.
| Dr | Encumbrance |
| Cr | Budgetary account |
For any expenses that occur afterward that relate to the encumbrance, companies must use the following journal entry to update the account.
| Dr | Expense |
| Cr | Encumbrance |
Conclusion
Encumbrance is a claim or liability that restricts the use of an asset. The term applies to various areas, including mortgages, real estate, accounting, and transfer of assets. In accounting, encumbrance refers to an account that holds reserve funds for a specific expense or a purpose. Once those expenses occur, companies can use the reserve funds.
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