All You Need to Know About Fund Accounting for Nonprofits
Fund accounting sounds exciting, right? Fund accounting is an accounting method that is mandatory to use when receiving donor-designated funds. Because it helps the nonprofit maintain transparency on how the money received is spent, it is a nonprofit accounting standard. It allows a nonprofit to keep better track of and monitor all assets, liabilities, incomes, and expenses related to a specific fund. At the end of the day, each fund will have its own self-balanced accounting, which is a best financial practice for nonprofit organizations with these requirements.
In this article, we will go a bit beyond the nonprofit accounting basics and accrual accounting basics to examine fund accounting in greater detail, including a definition of funds, how they are tracked, and some tips you can use to guide your own nonprofit organization.
Here’s what we’ll cover:
- Understand Fund Accounting
- So What is a Fund?
- The Different Types of Funds
- When to Use Fund Accounting
- A Few Tips Around Fund Accounting
First, let’s take a closer look at fund accounting as a whole. This will help to give a better grasp of the techniques utilized in this system.
Understand Fund Accounting
Fund accounting is a method of accounting that allows a nonprofit to separately follow multiple activities within the organization. It can also be used to refine the monitoring of your organization, as well as ensure complete transparency in the use of certain sources against your budget.
When you receive revenue, whether it be through donations, grants, state aid, or other sources, you want to be able to demonstrate not only profitability but also accountability. Each activity followed, also known as a fund, will have its own set of accounts that are self-balancing (assets, liabilities, revenue, expense, and fund balances or net assets).
For example, let’s say that your nonprofit is set up to help communities in need. You have just received a grant that has been earmarked to fund scholarships for a group of children in India who have been orphaned due to a natural disaster.
In order to adhere to the proper nonprofit cash handling procedures, you take this cash and deposit it into your company account. This is where your fund accounting will kick in. If it is properly set up, this amount becomes a separate entity within the larger scope of your organization. This fund will have its own set of assets, liabilities, income, equity, and expense balances. Still a part of the greater whole, it retains its own accounting.
So What is a Fund?
For a quick rundown of nonprofit accounting terms, a fund is essentially any area of your organization where activity must be accounted for separately. It becomes like a mini-organization with its own independent accounting system. Yet in the end, all of the funds accounting will be consolidated into the overall accounting of the nonprofit. It is a system within a system.
What is a fund, you ask? Emily is thinking the same thing!
Here is a comparison of general accounting vs fund accounting:
General Accounting: A regular for-profit business (let’s say a bookstore), has all of its resources grouped together. These resources may be used for any purpose of the business. The final matching of revenues against expenses comes out as either net profit or loss.
Accountability is necessary for regulating agencies, owners, and consumers.
Fund Accounting: Now we will look at a nonprofit organization. Let’s stay with the book theme. This organization provides books to underprivileged communities. They receive large donations from various high-profile donors, as well as a grant from a government agency.
Each large donation, as well as the grant, will be counted as their own entity. They are tracked within themselves, and then as a part of the larger organization. These may look like:
$3,000 donated for the creation of small community library downtown
$2,000 government grant for stocking high school library
$1,000 for distribution of free books to qualifying low-income families
Accountability is necessary for regulating agencies, legislature, and contributors of the funds (e.g. large donors and for future grants).
Pro Tip: When a donor gives money to a nonprofit organization, they can ask for it to be classified as a "donor-designated" fund. This means that the money can only be used for the specific purpose it was donated to. (For example, see the $1,000 donated in our book charity scenario. This amount had a strict designation).
The Different Types of Funds
Funds are usually categorized into three main funds:
Unrestricted Funds: These are funds donated to a nonprofit for any use or purpose. Many nonprofits choose to use these to go toward operating expenses or a project of their choice. A common example of unrestricted funds is general donations made to the annual fund. For example, if a member includes a gift of $100 on their membership dues renewal notice, that money is not typically designated for a specific purpose and can be used for any purpose by the organization.
Permanently Restricted Funds: These funds are donated to an organization to be used in a designated way and the principal cannot be spent. Typically these types of funds are invested so that they can generate interest revenue to support the program. They can be structured as an endowment if the program is expected to last in perpetuity. Generally, these are set up to support large-scale programs over time. For example, an individual donates a large chunk of real estate to your public university. Congratulations! However, there is one major caveat. The donor has specified that the property can only be used to house research labs. This donation would be considered permanently restricted.
Pro Tip: Consult with an investment consultant before setting up your permanently restricted investment account so that you can develop a strategy that will help you meet the program goals. A common program supported by permanently restricted funds includes grant programs to support the organization’s mission.
Temporarily Restricted Funds: These are funds that are time-bound and are earmarked to be used for a specific project within a specific period. When that time period ends, or the project is completed, then these funds are either stopped or become unrestricted. Temporarily restricted funds can be raised via a specific campaign and as noted usually have time restrictions on when they should be or are expected to be used. Let’s revisit our initial example of the nonprofit that received a grant for the scholarship for Indian children orphaned by natural disaster. Once the mission has reached its goal and the scholarships have all been awarded, any money that is left over from the grant must be reinvested into the program. Thus these funds are considered temporarily restricted.
Within each of these categories, multiple subcategories can be created: grants, campaigns, or missions.
When to Use Fund Accounting
If you need to be able to determine how much money is earmarked for various program purposes, fund accounting is likely the appropriate route for your organization as a whole or for the program in question.
Corinne is taking notes on when to use fund accounting.
Notably, by separately tracking the costs and expenses of a specific program, fund accounting will allow you to address a couple of key points. Let’s look at our example again:
How to record the receipt of x amount of dollars received for the scholarship of orphaned kids.
How to properly record the n scholarships that have been issued thanks to this grant.
At any given point in time, how much of this grant is left to spend toward future scholarships?
A Few Tips Around Fund Accounting
Now that you have a better understanding of what fund accounting entails, we’ll go over some tips, and nonprofit accounting resources, you can use when utilizing this system.
Designation of Funds
It is up to the donor themself to decide whether their donation must be restricted or unrestricted. This designation is given either by a letter sent from the donor to the organization or through any other type of written agreement between these two parties.
It is the responsibility of the nonprofit to clearly state through their donation form what type of donation they accept. If they are not equipped to implement fund accounting, then they may only ask for unrestricted funds.
Think Beforehand About Your Accounting Structure
If you are just getting started or are new to nonprofit accounting altogether, think very carefully about funds that need to be tracked separately. Trust us, do your best to keep things as simple as possible by not taking on multiple funds at one time. With too many funds, it can become a nightmare to manage and you will be hard-pressed to keep good track of anything!
Potentially, within a fund, if you want to be able to follow two programs, you may want to attribute specific program codes within your chart of account. However, there is no need to create a new fund.
Pro Tip: You do not need to set up a separate bank account for each fund. Simply keep track of them separately in your accounting software or excel spreadsheet.
Cost Accounting vs Fund Accounting
For those who are familiar with accounting terminology, in some ways fund accounting can be compared to cost accounting. However, contrary to fund accounting, which is more complete as an accounting system (as seen earlier, each fund has its own liability, income, and expense), cost accounting is mostly a P&L (profit and loss) view of a specific program.
You may want to apply this type of monitoring (which is more simple due to being focused on expenses and incomes) for diverse campaigns, projects, or even events. This dedicated cost follow-up should not be mistaken for fund accounting. In these cases (especially that of events) there is no specific designation of funds.
For example, cost accounting would be used to track the P&L of a specific fund drive, or perhaps a charity gala with a silent auction. Neither of which handles designated funds.
To sum up, cost accounting and fund accounting are both systems that account for specific projects within a nonprofit’s purview. But while cost accounting can be applied to any type of campaign, fund accounting is necessary for designated funds because it is more detailed.
Automate With Accounting Software
Fund accounting as a concept is fairly easy to understand, but not so simple to implement. Performing fund accounting when bookkeeping for nonprofits can be complex, especially if you are dealing with multiple fund streams.
Sam is finding a great way to automate his fund accounting!
A best practice is to use an accounting tool such as FASB-approved fund accounting software to remain compliant with GAAP standards for nonprofits. There are several of these available on the online market. Quickbooks is a popular choice. A fund accounting tool will provide features like a self-balancing set of accounts, designed for use with a specific project, grant, or donation. This is in addition to more common activities like a balance sheet, revenue sources form, and financial reports like net assets, overhead, and actual revenues.
Although tempting, try not to try to "boil the ocean!" If in your 501 c3 accounting practices you find you need to take on complicated designated funds, consider bringing on an accountant for your nonprofit organization. Many organizations that have successfully moved past the 501 c3 application stage find that they need at least a full-time accounting professional on staff. Alternatively, they can have a staff member participate in nonprofit accounting courses, to properly track the movement of all these funds.