Definition

Earmarking

  • Updated on

What is Earmarking?

Earmarking is the process of setting aside or flagging a particular account or sum of money towards a specific purpose. Earmarking is widely used in numerous contexts, such as accounting, banking, finance, IT, etc. Earmarked funds are not available for other uses. The term can also be used to specify a potential charge on some assets in case of provisioning or bankruptcy. For individuals, it may mean assigning a symbolic value to one's funds. The practice ensures that funds are not utilized anywhere else. Opportunity costs of earmarking funds are much lesser than facing losses on contingencies.

 

Summary
  • Earmarking setting aside appropriate amounts of money for specific purposes.
  • Earmarking may relate to a company's budget spending or for individuals assigning a symbolic value to one's funds.
  • Earmarking ensures the availability of funds for required purposes and protects the funds from getting utilized elsewhere.

Frequently Asked Questions (FAQ)- 

What are the forms of Earmarking?

Earmarking of funds can be of two types-

  • Earmarking Revenues- means allocating all or some parts of the revenue for certain purposes, such as creating statutory reserves or provisions for taxation.
  • Earmarking Expenditure – it is proportioning a certain percentage of the budget towards a certain expenditure area. For example, allocating 10% of the total budget spend towards capital Expenditure.

How is term Earmarking used in different settings?

Earmarking is used to describe certain scenarios depending on the circumstances, take for instance-

  • In Agricultural Settings- It is often used to describe a cattle group that belongs to a certain farmer. The earmarking word originates from the practice of farmers cutting identifiable marks on their livestock's ears to reflect possession. 
  • When used in Social Science- it is used to describe behavioural economics. People often tend to earmark their funds for their loved ones. They tend to be extra careful with such funds. Take, for example, Mr B, who earmarks 10% of his salary for his daughter's education. He will not want to compromise on it or spend it elsewhere. There is a certain extra value he will assign to such funds. Such Earmarking makes the funds non-fungible. In no case will he take up this part of his income and utilize it for household expenses.
  • Under the Bankruptcy Law- Earmarking sets aside certain borrowed assets of a bankrupt party as not available for resolving bankruptcy. It stands on the idea that the borrowed funds never really belonged to a bankrupt party. So actually, it doesn't result in a net decrease in the bankrupt party's asset base. Meaning borrowings or loans of a bankrupt party have been earmarked, protecting it from the claims of other parties.
  • When used by Governments- It usually means that funds are allocated to a purpose that might otherwise be a cause of the problem to the national policies at large. In the case of government spending for Covid-19 related unemployment benefits, governments have earmarked funds. Fund was earmarked to provide for the public's salary loss due to Nationwide lockdown. Lockdowns were essential, but people could not have agreed to it if they didn't get any funds in turn for the salaries lost.

Example-

To understand Earmarking better lets', consider an example of a company Delta ltd., that issues AU$5 billion of bonds in 2021. Out of these bonds issued to the public, AU$200 million is earmarked for enabling digital operational setups at its new factory. Funds are explicitly needed to connect the factory to its ERP and make factory data available to administrative departments. It means that company Delta ltd. Can set aside AU$200 million of the bond receipts in a separate account as earmarked funds for digital enablement of factory operations. They can be shown separately in the books of accounts as not available for other use. Such facts about earmarked funds need to be made public to investors. Earmarking does not allow the use of funds for any other purposes.

Another example is when an organization sets aside funds for regular tax deductions.

Image source: © Walldemarus | Megapixl.com

How are earmarked funds accounted for?

Earmarked Funds are often shown under the Commitments/Reserves account in an annual report. Any other method of reporting such funds may be specified by the applicable laws or generally accepted country's accounting principles.

Any note to accounts talking about earmarked funds must mention all entailing details. It must mention specific bank account details of the earmarked funds. Such accounts will then not be considered a part of liquid bank balances or available funds.

What are the Pros & Cons of earmarking?

Pros-

  • Earmarking guarantees fund availability as and when required.
  • It increases the accountability of available funds with an organization.
  • It helps builds support on political or legislative decisions.
  • With Earmarking, there is an increased awareness of costs.

Cons-

  • Earmarking brings in the rigidity of funds in an organization.
  • It is by nature only an appropriation of funds, just a classification change.
  • The process shrinks the base of funds available for operations and other payments.
  • With Earmarking, the Fungibility of funds is lost.

How can earmarking funds be useful in Investing?

While creating an investment portfolio, it is common for individuals or portfolio managers to earmark funds for specific purposes. If A Wealth manager receives, say, AU$1 million from Mr. X, he will first assess his investment goals and plan out investments accordingly.

If the goals include purposes like funds for children's education or retirement needs, the wealth manager will earmark investments accordingly. In this way, he will fix the use of certain investments to achieve the educational needs of his children, and the manager will make other investments to achieve retirement needs. Usually, investments earmarked for immediate needs are directed towards growth assets. On the other hand, stable income-generating investments may be earmarked for post-retirement life. 

Earmarking investments provides clarity on the funds available to achieve investment goals. It also helps identify costs associated with these investments.