Fund accounting is an accounting practice that’s common among nonprofit organizations. Unlike traditional accounting processes that focus on recording profits and losses, it focuses on tracking money to make sure it’s being used for its designated purpose.
One key feature of fund accounting is the use of accrual accounting. With accrual accounting, organizations can record financial transactions as they happen, providing a more accurate picture of their financial health.
In this article, we will define fund accounting, explain how it works and its advantages and disadvantages, and also discuss the types of funds that use this method of accounting. Here’s what you need to know about fund accounting:
Defining fund accounting
Fund accounting is primarily seen in nonprofit organizations, government agencies, and churches. While standard business accounting measures the profit a business generates, fund accounting is all about accountability for financial resources. It allows organizations to keep tabs on money assigned for specific purposes to ensure it’s spent as intended.
It uses accrual accounting, and each stream of funding has a distinct code in the ledger to identify it, such as grants, donations, and government contracts.
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, such as specific revenue funds, permanent funds, general funds, debt service funds, and capital project funds.
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.
Characteristics of fund accounting
Fund accounting is helpful to manage restricted funds that are earmarked for a specific purpose. But fund accounting can also include unrestricted funds that can be used for any purpose. Regardless of the fund type, nonprofits need to show fund activity and transactions by preparing financial statements, such as:
Advantages of fund accounting
Fund accounting has benefits for accountability and responsible financial management. It helps organizations maintain transparency by reporting on how they use the money.
By categorizing funds into fund accounts, organizations can easily demonstrate compliance with any restrictions placed on the use of the money. Donors, government agencies, and other stakeholders often appreciate this transparency.
Disadvantages of fund accounting
While beneficial in many ways, fund accounting comes with its own challenges. It requires additional effort and resources to meet the financial reporting requirements of managing separate funds. You’ll need financial records and reports for each fund, which can be time-consuming.
Another disadvantage is that it doesn’t show the complete picture of an organization’s financial health. Unlike traditional methods of accounting, which consolidate all financial data, fund accounting separates finances based on the specific purpose or source of funds.
Types of funds in nonprofits
Nonprofit organizations can have different types of funds beyond restricted or unrestricted. Additional categories can include temporarily restricted or board-designated. Here’s a look into each type to better understand the characteristics and applications.
Restricted funds are specific amounts of money set aside (or “restricted”) for a particular purpose, and the organization is legally obligated to spend it only for that purpose. Donors typically provide these funds with guidelines on how they can be used.
For instance, a provider might give a nonprofit organization funds for a new building project, research on a particular issue, or a scholarship for underprivileged students.
Unrestricted funds, on the other side, 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 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.
Using fund accounting software
Organizations have a few options to keep their books in order, including enlisting the help of a CPA, using accounting software like Xero, or both. Using online software can simplify the process by automating various tasks and streamlining workflows. It’s a flexible and efficient option to track and manage multiple funds.
Fund accounting software makes sure transactions are properly recorded and allocated to the correct fund. It also helps to simplify budgeting, forecasting, and financial analysis to manage financial resources better and offer valuable insights into the organization’s financial performance.
Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the content provided.
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