Government Technology Implications: Budgets and Commitment Accounting
This is section 2.3 of a series of blog entries creating a Government IFMIS Technology Evaluation Guide. This includes information to assist in evaluating IFMIS options and the technology requirements for FreeBalance IFMIS implementations. These series will be combined with feedback to produce a comprehensive Technology Evaluation Guide to be published on our web site.
Government financial management is different from the private sector, particularly for budgets and commitments. This is often called ‘Commitment’ or ‘Encumbrance’ accounting. Financial Accounting relates to transactions that affect the General Ledger such as revenue, payroll and purchasing.
Private sector accounting focuses on the ability of companies to manage for the “bottom line”: profit. Governments do not manage for profit. The government “bottom line” is budget. The budget represents the legal embodiment of government policy. Commitment Accounting precedes the traditional accounting cycle and typically contains the following elements:
- Draft budget plan – consists of budget estimates that have yet to be approved.
- Budget – consists of budget at the line item level.
- Appropriations, allotments or warrants – consist of budgetary information that authorizes spending. These can be combinations of short and long term allotments.
- Commitments – represent the start of a spending process through the generation of a Purchase Requisition. A commitment sets aside an estimate amount from the budget. This prevents other commitments that could exceed the budget.
- Obligations – represents a legal obligation with a supplier through the generation of a Purchase Order. The obligation can be at a different amount that the estimate. The original commitment is de-committed. The commitment is replaced by the obligation. (The government may elect not to enter into a contract. The entire amount is de-committed and made available in the budget.)
- Payments – actual payments made. The payment de-obligates and replaces the obligated amount with the actual amount that could be different.
- Budget transfers and virements that change the budget amounts to reflect changes in need or government financial position. For example, the government may recognize that there will be revenue shortfalls and adjusts the expenditure budget. Or new priorities require transferring budget to different programs.
Commitment accounting requires many steps prior to affecting the General Ledger. Government financial management systems must track the status of all of these steps to ensure that the budget will not be overspent. The available budget for spending is often referred to as the “free balance” where:
free balance = budget – (commitments + obligations + actuals)
The status of budgets, commitments and obligations provide government decision-makers with trend information that can predict budget variances.
There are variations in Commitment accounting among governments including:
- Terminology: commitments are often termed “soft commitments” or “pre-encumbrances”. Obligations are often termed “hard commitments” or “encumbrances”
- 1 or 2 Commitment stages: some governments do not track the “soft” commitment as affecting the budget. This is often the case when the government is modernizing and has lower human capacity so processes should be streamlined. It is also the case when the government organization is of a modest size where there is limited value to having soft commitments.
- 1 or more allotments: some governments leverage more than one appropriation. For example, governments often have an annual appropriation that is used for predicting budget variance for the year, and a monthly warrant or authority to spend.
- Cash or Accrual Accounting: some governments use modified or full accrual accounting that hits the General Ledger when the goods or services, and invoice, have been received.
- Multi-year Commitments: governments often have different rules for commitments that can span more than one year. Some types of goods or services may need to be delivered in the fiscal year otherwise the contract is cancelled.
There are many benefits to the use of Commitment Accounting in government including:
- Ensuring sufficient funds are available to meet contractual needs
- Guaranteeing that budgets will not be overspent
- Helping in planning for future costs
- Assisting in determining flexibility in adjusting budget transfers
- Predicting budget variances to speed up or slow down spending to meet government objectives
- Balancing the budget cycle with the General Ledger to ensure information integrity
Tags: budget, Commitment Accounting, commitments, encumbrance, obligations
April 29th, 2009 at 4:12 am
This is exactly what I was looking for in trying to get a governmental department to think outside the box in a HUD RFP. I used to teach the Becker CPA course (the other instructors let me teach governmental accounting because they couldn’t handle it) and I could not remember the term for commitments that carried over a budgetary period end. It is “encumbrance”. Thanks, this is the key to bridging our private side supplier concept to their public side mental “box”
April 29th, 2009 at 4:22 pm
Terminology differs among governments. There are 2 commitment steps in use by many governments. The first typically occurs at the purchase requisition where money is set aside from the budget to begin the purchasing cycle. This is known as a “commitment”, “pre-commitment”, “soft commitment” or “pre-encumbrance” because it has no legal obligation to the government. Some governments do not track this step. The second step is when the purchase order or contract is provided to a vendor. This represents, in most government, a legal obligation of some sort and is termed a “commitment”, “hard commitment”, “obligation” or “encumbrance” depending on the government. Some governments do not consider a purchase order to be a legal obligation and only obligate when goods/services have been received.
Any commitment or obligation can carry over to a following period or fiscal year depending on government rules. It is typical for a capital budget item to carry over a year. Some contracts may also carry over one or more years. This is most often called a “carry over” or “roll over”. Many call it these a “multi-year commitment.”
August 12th, 2009 at 6:23 am
Whilst I find this post interesting – albeit a little in-constructive, I completely agree with the first comment listed above and can relate to that persons position.
September 30th, 2009 at 5:06 am
I find this post interesting, it has brighten my knowledge in understanding other terminologies used in commitment accounting. I will appreciate if I can be assisted in getting a paper presentation on commitments accounting.
December 3rd, 2009 at 8:01 pm
Interesting post. I like your definition, but have a question for you around ‘carry over’ or ‘roll over’. I know that you want to carry over encumbrances (obligations) for Purchase Order, but my question is if you know of pre-encumbrances (commitments) being carried over. Pre-encumbrances represent requisitions and are not legal obligations yet, but would government still want to carry over, so they dont have to have the inconvenience of reversing all pre-encumbrances and then enter new requisitions in the new year?
December 3rd, 2009 at 9:20 pm
Good observation. Many governments do not use pre-encumbrances, and some do not consider purchase orders as obligations.
Capital projects tend to be multi-year in focus. The capital budget is, therefore, multi-year. Recurrent or operating budgets are usually legally determined in a year by year basis. Small capital expenditures are also restricted to the fiscal year. Multi-year capital expenditures typically support multi-year commitments meaning that the budget, pre-encumbrances and encumbrances are carried over to the next fiscal year. In fact, the government resource planning system will enable the government to set the estimated budget for each year.
Many governments do not enable multi-year commitments for recurrent budgets and small capital budgets. Pre-encumbrances are not carried over. Some countries will not carry over recurrent obligations because the contract will state that the products and services must be delivered before the end of the fiscal year. Of course, there will be a fiscal year-end procedure that makes sure that items received are captured in the financial system.
January 22nd, 2010 at 5:35 am
I would like to know more about the “multi-year commitments” concept as applicable to a government. Please could you share or point me to appropriate documentation regarding the same.
Thanks.
January 22nd, 2010 at 9:28 pm
Multi-year commitments is a standard in government resource planning and financial management. Unlike the private sector, government operates based on budgets and commitment accounting. Budgets are typically approved for a single year. Therefore, money budgeted for a particular purpose that is not spent in a fiscal year is lost to the treasury.
However, some programs are multi-year, typically large capital projects. Contracts for these projects are multi-year. So, the Purchase Order and Contracts are multi-year. Commitment Accounting software for government models these multi-year contracts as multi-year comitments. Differences between budget and actuals at the end of the year such as underspending or overspending are permitted as long as the multi-year commitment is not overspent or it does not exceed any other aggregate financial control.