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What Is Fund Accounting? Definition, Importance and How It Works

Fund accounting is a bookkeeping system. It is used by nonprofit and government organizations to focus on accountability for how they spend resources provided by donors or taxpayers that are designated for a particular purpose.

“Fund” used in this context doesn’t refer to an asset account, such as a mutual fund account, but rather the grouping of resources by the purpose they are intended to fund. By monitoring these funds, managers, donors and other stakeholders can ensure that nonprofits are spending donations and revenues as agreed upon or required by law.

There are some slight differences between fund accounting for nonprofit organizations and government entities. This article focuses on helping nonprofits understand the basics of fund accounting.



Fund accounting basics

Nonprofits must separate all their activities by fund. Essentially, each fund will have its own set of books and financial statements, but fund accounting software will account for all funds simultaneously in a single system and combine all funds automatically into a single set of financial statements for the organization. However, fund accounting software can also provide financial statements separated by fund when needed.

When a nonprofit records activity, it needs to not only choose the accounts affected but also designate a fund. For example, when a donation is received, it’s not enough to record the receipt of cash and the contribution income — you must also designate the fund for which this activity belongs.

Example financial statements by fund

To illustrate how each fund has its own set of financial statements, here is a sample balance sheet and statement of activities separated by fund for a hypothetical nonprofit. Externally issued financial statements generally will only show the amounts in the total column, but note that even the total column separates the “net assets” section of the balance sheet by fund (yellow highlights).

Example balance sheet by fund

Total Unrestricted general fund Unrestricted capital investment fund Permanently restricted – donor endowment
Assets
Cash 121,000 105,000 11,000 5,000
Investments 1,215,000 15,000 1,200,000
Fixed assets 500,000 500,000

Total assets

1,836,000

105,000

526,000

1,205,000

Liabilities
Accounts payable 13,000 13,000
Mortgage payable 150,000 150,000
Total liabilities 163,000 13,000 150,000
Net assets


Unrestricted general fund


92,000

92,000

Unrestricted capital investment fund

376,000

376,000

Permanently restricted – donor endowment

1,205,000

1,205,000

Total net assets

1,673,000

92,000

376,000

1,205,000

Total liabilities and net assets

1,836,000

105,000

526,000

1,205,000

Example statement of activities by fund

Total General fund Capital investment fund Permanently restricted – donor endowment
Revenues and support
Contributions 350,000 350,000
Investment income 110,000 110,000
Total rev and support 460,000 460,000
Expenses
Program services 325,000 325,000
Fundraising 10,000 10,000
Administrative 85,000 80,000 5,000
Total expenses 420,000 415,000 5,000
Change in net assets 40,000 45,000 –5,000
Beginning in net assets 1,633,000 47,000 381,000 1,205,000

Ending net assets

1,673,000

92,000

376,000

1,205,000

Notice that the financial statements don’t only balance in the total column, but each fund column also independently balances. On the balance sheet, total assets equals total liabilities plus net assets (blue highlights) for each column. The ending net assets on the statement of activities equals the total net assets on the balance sheet (green highlights) for each column.

Types of funds in fund accounting

When contributions to a nonprofit are designated by the donor for a specific purpose, they must be accounted for separately from other funds. Nonprofits create separate accounting by creating multiple funds of the following types:

  • Permanently restricted: Permanently restricted funds can only be used for a specified purpose, such as contributions that establish a permanent endowment whose principal can never be spent.
  • Temporarily restricted: Donations create temporarily restricted funds when they can only be used for a specific purpose until that purpose is achieved or sometimes after a certain amount of time has elapsed.
  • Unrestricted funds: Nonprofits are not obligated legally to use unrestricted funds in any particular manner.

Some organizations may not have any restricted funds, but all must have at least one unrestricted fund — usually called a general fund. Many organizations choose to create multiple unrestricted funds to track contributions and spending for multiple goals or activities.

For example, a church might track the following unrestricted funds:

  • Unrestricted missionary fund.
  • Unrestricted capital investment fund.
  • Unrestricted general fund.

While restricted funds are created by donors making restricted donations, unrestricted funds are created by the nonprofit’s management team for specific programs that they would like to track separately from the general fund. Amounts in unrestricted funds can be transferred to other funds if management decides they are needed.

In the example above, the church has allocated a portion of its resources to the missionary fund and capital investment fund. These unrestricted funds can be reallocated later if needed. These unrestricted funds exclude donations where the donor specifically instructed the church that the donation must be used for missionary work. If the church accepts that donation, then it would need to create a new fund called, “Temporarily restricted missionary fund.”

Importance of fund accounting

Fund accounting is crucial to ensure that nonprofits are complying with stipulations established by donors. In addition to restricted funds, tracking unrestricted funds by the purpose is useful to stay accountable to nonprofit stakeholders and contributors. Even donors who don’t stipulate a particular use are generally interested in how their donations are being spent.

Fund accounting helps nonprofit managers from overspending in one area to the detriment of another. Knowing the funds available for each of the major activities of the organization helps the budgeting process and with spreading the available resources properly across activities.

Who uses fund accounting?

Users of fund accounting can be split into three groups based on the complexity of their operations. The necessity of a solid understanding of fund accounting varies greatly among these groups.

1. Very small nonprofits with a single purpose

Very small organizations might have a single unrestricted fund, so fund accounting is pretty simple as all net assets of the organization belong in the single fund. These organizations can typically use inexpensive accounting software designed for for-profit organizations without any special modifications.

The amount shown as owner’s equity on the for-profit balance sheet should be labeled as unrestricted assets. Visit our guide to the best accounting software to find affordable for-profit accounting software that will work for nonprofits with only one fund.

2. Larger nonprofits without restricted funds

While there is no requirement to establish multiple unrestricted funds, larger organizations that collect donations and spend money on multiple programs can benefit greatly from using fund accounting.

Each major program should have a separate unrestricted fund. By tracking the donations, revenues and expenses separately, donors can see how their donations are being spent. In addition to transparency, the separate funds ensure that managers know the exact resources available for each purpose.

3. Nonprofits with restricted funds

Fund accounting becomes critically important for organizations accepting restricted donations. Restricted donations are usually large donations that come with legal documents, such as a will or trust, which provide very specific, legally enforceable stipulations on how the money can be used. If nonprofits spend the money in any other way, they can be sued by the donor or their representatives.

Fund accounting best practices

1. Use accounting software designed for fund accounting

Traditional accounting software programs are not designed to be used for fund accounting. While nonprofits with no restricted funds and only one unrestricted fund can get by using traditional for-profit software, other organizations need to invest in fund accounting software. Fund accounting software tends to be a bit more expensive but will minimize fund accounting mistakes.

A less-expensive option to true fund accounting software is to use QuickBooks and create a class for each fund. You can print your financial statements separated by class, which mimics fund accounting. You’ll need to be vigilant to always assign a class to every transaction. Visit our guide to the best nonprofit accounting for additional options.

2. Create restricted funds

It is critical that a separate restricted fund is created for each donation or set of donations with unique restrictions and spending requirements. If you receive restricted donations through wills frequently, you’ll need a separate restricted fund for each bequeath.

3. Create unrestricted funds sparingly

While it is good to create separate unrestricted funds for your major program services, creating unnecessarily narrow unrestricted funds will cause headaches without adding much value to your accounting system. For example, if you manage several homeless shelters, it’s probably unnecessary to create a separate unrestricted fund for each location.

4. Give your donors a list of projects to support

Many donors like to have input on how their money is spent, so you can save a lot of headaches by allowing them to choose from a list of restricted funds for which you’re seeking additional support. Donors often don’t realize what an incredible accounting headache they create when they designate their donation for a unique purpose.

For example, say you’re a nonprofit offering childcare to allow parents to attend classes you provide. A thoughtful donor might think that is a wonderful idea and designate that their donation go toward this program. However, they don’t realize that for the nonprofit to accept their donation, it must create a separate restricted funds account.

5. Think twice before accepting restricted funds

It’s hard to turn away money, but think things through before accepting restricted funds if you’re a small organization. You must be 100% confident that your nonprofit has the proper fund accounting, controls and oversight to guarantee the money is spent properly.

Be sure to consider if you’ll need to incur additional expenses like upgrading to a more sophisticated accounting software or outsourcing your accounting to a nonprofit accounting pro. Mistakes can result in litigation that might drag your organization through the mud and affect donations from other donors.

Before refunding restricted donations, explain your situation to the donor and see if they’ll allow you to accept the donation as unrestricted. This might work for small donations; for instance, when a donor provides a designated purpose in the memo section of their check. However, larger restricted donations through trusts and estates may not be flexible.

6. Don’t physically segregate assets by fund

As discussed above, each fund is essentially its own set of books complete with assets, liabilities and a fund balance. However, it is unnecessary — as well as often creates unnecessary work — to separate each fund’s assets physically in a separate bank account. For example, cash for all funds can be kept in the same checking account and then each fund’s share of the checking account balance is tracked in the fund accounting software.

Difference between fund accounting vs. regular accounting

Fund accounting Regular accounting
Objective Provides accountability to show that organization resources are spent in accordance with legal requirements and donor intentions Measures profit and loss for a period and tracks profits that are paid to owners versus retained by the company
Best for Nonprofit and government organizations For-profit companies including sole proprietors, partnerships, S-corps and C-corps
Required financial statements Balance sheet
Statement of activities and change in net assets
Statement of cash flow
Balance sheet
Statement of profit and loss
Statement of cash flow
Statement of owner’s equity
Balance sheet formula Assets = Liabilities + Fund Balance Assets = Liabilities + Owner’s Equity
Net asset accounts Permanently restricted funds
Temporarily restricted funds
Unrestricted funds
Contributed capital
Retained earnings
Primary users of financial statements Donors, taxpayers, creditors and regulators Owners, creditors and regulators
Complexity of bookkeeping More complicated than regular accounting because all transactions must be assigned to specific funds Less complicated than fund accounting

Frequently asked questions

What is the concept of funds in accounting?

Funds in accounting can sometimes refer to available cash, but when used in the context of “fund accounting,” it’s different. In fund accounting, a fund is a separate set of books maintained by nonprofits that tracks the assets, liabilities, income and expenses designated for a particular purpose. Nonprofit accounting combines all the separate funds into a single set of financial statements.

What do you mean by fund-based accounting?

Nonprofit and government organizations use fund accounting to track assets, liabilities, revenue and expenses separately for designated purposes. It provides additional transparency and accountability to stakeholders by showing how contributions and earnings are spent.

What does a fund accountant do?

“Fund accountant” can refer to two completely distinct jobs. In investment accounting, a fund accountant helps record transactions and calculate the fair market value of an investment fund, such as mutual funds. In nonprofit and government accounting, a fund accountant is a bookkeeper with specialized knowledge of how to separately track activity by designated purposes.

Bottom line

Fund accounting requires nonprofit and government organizations to account for restricted or designated funds separately from unrestricted funds. This is done by creating a separate set of books for each required fund. Good fund accounting software is essential as it allows for the maintenance of a separate set of books for each fund while also being able to consolidate them easily into a single set of financial statements.

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