What is fund accounting? Basics, types, and benefits

Published Friday 17 April 2026

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
• Best practices for 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).
• Use 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 an accounting method that tracks money by its intended purpose rather than overall profitability. Unlike traditional accounting, which measures profit and loss, fund accounting focuses on accountability and compliance with spending restrictions.

This approach helps nonprofits, government agencies, and churches demonstrate that donated or restricted funds are spent exactly as donors or regulations intended.

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

Each fund account includes:

• Dedicated assets and liabilities: separate financial records for each fund
• Individual revenue and expense tracking: isolated transactions from other funds
• Unique balance sheet: the fund's complete financial position
• Distinct ledger codes: identification of 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

Fund accounting differs from traditional accounting in its primary goal. Traditional business accounting measures profitability to see if a company is making or losing money. Fund accounting focuses on accountability and compliance instead.

The main purpose of fund accounting 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're using their financial resources responsibly. The Government Accountability Office (GAO) has been auditing the federal government's consolidated financial statements since fiscal year 1997, underscoring this standard of accountability.

Organizations that use fund accounting

Fund accounting is most common in government entities and nonprofits. Organizations that typically use this method:

Government entities

Government agencies at all levels use fund accounting to track public resources.

• Federal, state, and local government agencies, which follow generally accepted accounting principles (GAAP) developed for federal entities as outlined in the comprehensive Federal Accounting Standards Advisory Board (FASAB) Handbook
• Organizations managing general funds, special revenue funds, permanent funds, debt service funds, and capital projects funds

Nonprofit organizations

Many types of nonprofit organizations rely on fund accounting.

• Churches and religious organizations
• Hospitals and healthcare facilities
• Universities and colleges
• Nursing homes
• Artistic foundations
• 501(c)(3) organizations registered with the Internal Revenue Service (IRS)

Fund accounting helps these organizations track how 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. Official government standards provide classifications based on the relative strength of the constraints that control how specific amounts can be spent. Each type has distinct characteristics and applications.

Restricted funds

Restricted funds are donations with specific spending requirements that create legal obligations for the organization. They often involve one or more barriers and a right of return to the contributor if conditions aren't met. Restricted funds work as follows:

• 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, and challenge (matching) grant agreements

Misusing restricted funds can result in legal penalties and loss of nonprofit status.

Unrestricted funds

Unrestricted funds are donations without specific donor instructions. The nonprofit can use these funds based on its needs and objectives.

Common uses for unrestricted funds include:

• Operational expenses
• Emergency repairs
• Mission-aligned initiatives

Temporarily restricted funds

Temporarily restricted funds have stipulations that expire once certain conditions are met. These funds are reclassified as unrestricted when the restriction ends.

Two conditions can lift restrictions:

• Time-based: the restriction expires after a set period
• Purpose-based: the restriction ends when a specific goal is achieved

For example, funds designated for a three-year scholarship program become unrestricted after three years.

Board-designated fund

Board-designated funds are unrestricted funds set aside for a specific purpose by the nonprofit's board. The board makes these designations internally rather than donors.

For example, a board might designate funds for:

• Future expansion projects
• Capital improvements
• Strategic initiatives supporting organizational 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, while 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
• : 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. These improvements in financial management led to over 20 Chief Financial Officer (CFO) Act agencies receiving clean opinions between fiscal year 2011 and 2020. Key benefits include:

• Transparency: show exactly how money is spent through detailed reporting
• Compliance demonstration: prove adherence to donor restrictions easily
• Stakeholder confidence: let donors and agencies verify proper fund usage
• Risk reduction: prevent 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: maintain separate records and reports for each fund
• Higher time investment: track and report more detailed information
• Limited financial overview: navigate fund separation that can obscure overall organizational health
• Complex reporting: manage multiple financial statements instead of consolidated views

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

Best practices for fund accounting

Effective fund accounting requires consistent processes to maintain compliance and build donor trust. Follow these best practices to manage your funds successfully:

• Maintain clear fund separation: keep each funding source in its own account with distinct tracking codes
• Document all restrictions carefully: record donor requirements and grant conditions at the time of receipt
• Reconcile funds regularly: review fund balances monthly to catch errors before they compound
• Communicate with donors: provide transparent updates on how restricted funds are being used
• Plan for annual reporting: schedule time before year-end to prepare required financial statements and compliance documentation

These practices help you stay organized, meet regulatory requirements, and demonstrate accountability to your stakeholders.

Using fund accounting software

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

• Professional Certified Public Accountant (CPA): get expert guidance for complex compliance requirements
• Accounting software: automate tracking and reporting with tools like Xero
• Combined approach: use software for daily operations and a CPA for oversight and compliance

Key software benefits include:

• Automated fund allocation: reduce manual entry errors
• Streamlined reporting: generate required financial statements automatically
• Multi-fund tracking: manage multiple funding sources simultaneously

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

Simplify your fund accounting with Xero

Transparency and accountability build trust with donors and stakeholders. The right tools make fund accounting straightforward so you can focus on your mission.

Xero helps you track different funds, manage expenses, and generate compliance reports. Simplify your bookkeeping and run your organization with confidence. Ready to make financial management easier? You can get one month free and see how Xero can support your goals.

FAQs on fund accounting

Common questions about fund accounting:

What is an example of fund accounting?

A university receiving a donation specifically for its library creates a separate fund to track that money. This ensures the donation is only used for library-related expenses like books or equipment.

What are the three main types of funds?

Fund accounting groups funds into three categories:

• Governmental funds: support general citizen services
• Proprietary funds: cover business-like activities such as utilities
• Fiduciary funds: hold assets in trust for others

Do small nonprofits need fund accounting?

Yes, even small nonprofits benefit from fund accounting. It's essential for maintaining donor transparency, meeting grant requirements, and ensuring restricted donations are used correctly.

How do I transition to fund accounting?

Start by reviewing your current funding sources and identifying which donations have restrictions. Then set up separate accounts for each fund type in your accounting software. Establish tracking codes and document all donor requirements. Work with an accountant experienced in nonprofit accounting to ensure proper setup.

What are common mistakes to avoid with fund accounting?

The most common mistakes include mixing restricted and unrestricted funds, failing to document donor restrictions at receipt, and not reconciling fund balances regularly. Avoid these mistakes by maintaining clear separation between funds. Record all restrictions immediately and review balances monthly.