Fund accounting explained: Types, benefits, and how it works for your small business

Published Wednesday 26 November 2025

Table of contents

• Defining fund accounting
• Fund accounting vs traditional accounting
• Organizations that use fund accounting
• Types of funds in nonprofits
• Characteristics of fund accounting
• Advantages of fund accounting
• Disadvantages of fund accounting
• Using fund accounting software
• Simplify your fund accounting with Xero
• FAQs on fund accounting

Key takeaways

• Implement fund accounting to create separate accounts for each funding source, ensuring donated or restricted funds are spent exactly as intended by donors or regulatory requirements.

• Recognize the four main fund types in nonprofits—restricted funds (donor-specified spending), unrestricted funds (flexible organizational use), temporarily restricted funds (time or purpose limitations), and board-designated funds (internally allocated for specific purposes).

• Utilize fund accounting software to automate complex multi-fund tracking and generate required financial statements, reducing manual errors while maintaining compliance with donor restrictions and regulatory requirements.

• Prepare for increased administrative complexity by allocating adequate staff time and accounting expertise, as fund accounting requires separate record-keeping and reporting for each fund compared to traditional business accounting methods.

Defining fund accounting

Fund accounting is a specialized accounting method that tracks money by its intended purpose rather than overall profitability. It's primarily used by nonprofit organizations, government agencies, and churches.

Traditional accounting focuses on profit and loss. Fund accounting focuses on accountability and compliance with spending restrictions.

This system allows organizations to demonstrate that donated or restricted funds are spent exactly as intended by donors or regulatory requirements.

Fund accounting creates separate accounts for each funding source to maintain clear financial boundaries.

Each fund account includes:

• Dedicated and : separate financial records
• Individual revenue and expense tracking: isolated from other funds
• Unique : shows the fund's complete financial position
• Distinct ledger codes: identify funding sources like grants, donations, or contracts

This separation ensures organizations can prove compliance with donor restrictions and regulatory requirements. It uses accrual accounting principles throughout.

Fund accounting vs traditional accounting

While both fund and traditional accounting track an organization's finances, they focus on different goals. Traditional business accounting measures profitability to see if a company is making or losing money.

Fund accounting, however, focuses on accountability—a principle shaped by standards that have undergone significant and far-reaching change over the last few decades. Its main purpose is to show that funds are being spent according to legal or donor-imposed restrictions. This makes it essential for nonprofits and government agencies that need to prove they are using their financial resources responsibly.

Organizations that use fund accounting

Various organizations can implement a fund accounting system, but it's most common in government entities and nonprofits. Federal, state, and local government levels use fund accounting. Entities can also set up categories to identify different revenue sources and expenditures, with official guidance clarifying the definitions of the general fund, special revenue fund, permanent fund, debt service fund, and capital projects fund.

Nonprofit organizations using fund accounting can include churches, hospitals, universities and colleges, nursing homes, and artistic foundations. It's particularly common among those registered as 501(c)(3) organizations with the IRS to show that spending is allocated for specific purposes. Fund accounting helps track how the money is used, who gave the funds, and how its use was restricted.

Types of funds in nonprofits

Nonprofit organizations can have different types of funds, with official government standards providing classifications like restricted, committed, assigned, and unassigned based on the relative strength of the constraints that control how specific amounts can be spent. Here's a look into each type to better understand the characteristics and applications.

Restricted funds

Restricted funds are donations with specific spending requirements that create legal obligations for the organization.

How restricted funds work:

• Donor control: contributors specify exactly how money must be used
• Legal obligation: organizations must spend funds only as directed
• Common examples: building projects, research initiatives, scholarship programs, equipment purchases

Why it matters: Misusing restricted funds can result in legal penalties and loss of nonprofit status.

Unrestricted funds

Unrestricted funds, on the other hand, don't come with specific donor instructions. Instead, the nonprofit can use the funds based on its needs and objectives.

A nonprofit might choose, for example, to spend unrestricted funds on operational expenses, emergency repairs, or any other initiative that aligns with the organization's mission.

Temporarily restricted funds

Temporarily restricted funds can have stipulations that can be met in two ways – the passage of time or fulfilling a certain purpose. Once the time restriction has passed or the goal has been achieved, the funds are reclassified as unrestricted. Funds meant for a scholarship program that spans three years is one example. After three years, any remaining funds become unrestricted.

Board-designated fund

Board-designated funds are set aside for a specific purpose by the nonprofit organization's board. Rather than based on donor guidelines, the decision to restrict funds is made internally. For example, a board might designate a portion of unrestricted funds for future expansion or a specific project to support the organization's growth.

Characteristics of fund accounting

Fund accounting manages both restricted and unrestricted money to ensure proper allocation and compliance reporting.

Restricted funds must be spent for specific donor-designated purposes. Unrestricted funds can support any organizational need that aligns with the mission.

All fund types require these financial statements:

• Statement of financial position: shows assets, liabilities, and net assets (balance sheet)
• : tracks revenues and expenses over time
• : monitors money movement in and out
• Statement of functional expenses: breaks down spending by program and support functions

Advantages of fund accounting

Fund accounting provides clear financial accountability that builds trust with donors and regulatory agencies.

Key benefits include:

• Transparency: detailed reporting shows exactly how money is spent
• Compliance demonstration: easily prove adherence to donor restrictions
• Stakeholder confidence: donors and agencies can verify proper fund usage
• Risk reduction: prevents accidental misuse of restricted funds

This transparency helps organizations maintain their nonprofit status and secure future funding.

Disadvantages of fund accounting

Fund accounting requires more complex record-keeping than traditional business accounting methods.

Main challenges include:

• Increased administrative work: separate records and reports for each fund
• Higher time investment: more detailed tracking and reporting requirements
• Limited financial overview: fund separation can obscure overall organizational health
• Complex reporting: multiple financial statements instead of consolidated views

Why this matters: Organizations need adequate staff time and accounting expertise to manage fund accounting effectively without overwhelming their resources.

Using fund accounting software

Fund accounting software automates complex tracking and reduces manual errors in multi-fund management.

Implementation options:

• Professional CPA: expert guidance for complex compliance requirements
• Accounting software: automated tracking and reporting (like Xero)
• Combined approach: software for daily operations, CPA for oversight and compliance

Key software benefits:

• Automated fund allocation: reduces manual entry errors
• Streamlined reporting: generates required financial statements automatically
• Multi-fund tracking: manages multiple funding sources simultaneously

This approach saves time while maintaining the accuracy required for donor and regulatory compliance.

Simplify your fund accounting with Xero

Managing your organization's finances with transparency and accountability is key to building trust with donors and stakeholders. Using the right tools can make fund accounting straightforward, freeing you up to focus on your mission.

Xero helps you track different funds, manage expenses, and generate the reports you need to demonstrate compliance. By simplifying your bookkeeping, you can run your organization with confidence. If you're ready to make your financial management easier, you can get one month free and see how Xero can support your goals.

FAQs on fund accounting

Here are common questions and answers small business owners might have about fund accounting.

What is an example of fund accounting?

A university receiving a donation specifically for its library would be a great example. The university would create a separate fund to track how that donation is spent, ensuring the money is only used for library-related expenses like buying new books or equipment.

What are the three main types of funds?

In fund accounting, funds are generally grouped into three categories: governmental funds (for general citizen services), proprietary funds (for business-like activities like utilities), and fiduciary funds (where assets are held in trust for others).

Do small nonprofits need fund accounting?

Yes, even small nonprofits benefit from fund accounting. It's essential for maintaining transparency with donors and is often required for grant applications. It helps ensure that restricted donations are used correctly, which builds trust and supports long-term growth.