What constitutes a valid encumbrance?
As part of our municipal audit procedures TLB has always incorporated procedures to evaluate the validity of budget encumbrances at year-end. TLB has noted in many communities and school districts year-end encumbrances practices and procedures are being followed without an understanding of the concepts underlying the encumbrance process. For our fiscal year 2007 municipal audits we have spent additional effort with our clients to ensure they understand what constitutes a valid encumbrance for annual operating budgets.
Whether an encumbrance is valid or not is ultimately a legal determination that potentially could require the consideration of a number of factors, provisions of Massachusetts General Laws and the facts and circumstances surrounding each individual encumbrance. However, in general the basic requirement to be met is that a binding contractual commitment or obligation must exist as of June 30 between the Town and a vendor.
In a 1992 letter to a local community from the DOR (DOR file #92-1012) the DOR opines, in part,
“The annual operating budget for each town department is authorization only to expend for obligations incurred during that fiscal year. Appropriated funds may be encumbered at the end of a fiscal year when goods or services cannot actually be delivered prior to June 30th, provided that a commitment to purchase them has been made during that fiscal year. Ordinarily evidence of that commitment may be made by means of a purchase order, accepted bid or signed contract.”
Furthermore, the DOR opines that school committees have wide latitude under MGL Ch 71, S 49A and under MGL Ch 71, S 34 to expend money at the end of a fiscal year – including for items intended for use in the following fiscal year. This treatment was supported by the Massachusetts appeals court case Wilmington v. Town Accountant of Wilmington (19 Mass. App. Ct. 964 (1985)).
It is important to note that a binding contractual commitment is not evidenced by a completed purchase order in and of itself – a binding contractual commitment must exist, in fact, verbal or otherwise. DOR letter 92-1012 provides in part,
“…there appears to be a dispute about whether there was a binding agreement to purchase the items in question. Although a purchase order may be evidence of such a binding commitment, it is not necessarily conclusive evidence if there is actually no contractual obligation to purchase the items. If verbal agreement to provide the goods was reached with the vendors prior to the end of the fiscal year, as the purchase orders suggest, then that would be sufficient to encumber the funds until delivery was made. However, if the town accountant is correct, and there was no commitment on the part of the town to the vendor nor any obligation on the part of the vendor to provide the goods, prior to July 1, 1992, then the purchase orders are insufficient to encumber the funds from the fiscal 1992 budget.”
Please contact TLB if we can provide you additional information or support on issues surrounding encumbrances. – posted by Rich Bienvenue