Reserve for encumbrances definition
/What is the Reserve for Encumbrances?
The reserve for encumbrances is an account containing that portion of a fund balance that has been set aside for the payment of an obligation. For example, the reserve could be used to pay for a maintenance contract or an issued purchase order. By using a reserve, a government entity is better able to control its expenditures by avoiding over-commitments of its funds.
A reserve is set up when a commitment is made to pay funds and the funds are available. When a billing is received from a supplier, the reserve is reversed and an account payable is recorded in its place.
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Example of a Reserve for Encumbrances
The City of Parched sets aside $2 million in funds for its storm water management department, which has the formidable task of collecting as much groundwater as possible to hold in reserve for the city’s dry season. At the start of the city’s fiscal year, the department manager decides to build a floodwater collection basin, which will cost $800,000. The manager signs a contract with a local contractor to handle the work. This results in the following entry:
The intent behind this entry is to reserve the cash needed to pay the contractor, which leaves $1.2 million of departmental funding available for other uses.
Eight months later, the contractor has finished work on the floodwater collection basin. To account for the department’s payment to the contractor, the accountant must first reverse the original entry, as follows:
A final entry records the $800,000 cash payment to the contractor, which is a cash reduction, and also a new fixed asset for the floodwater collection basin. The entry is as follows:
Throughout this series of transactions, the reserve for encumbrances was used to set aside a block of cash for floodwater management, so that it would not be accidentally used for some other activity. In short, it is a good way to maintain control over budgeted funds.