What is fund accounting? A complete guide to basics and best practices

Accounting rules vary depending on the organization.

For-profit businesses prioritize profitability, using traditional accounting methods to track financial performance.

In contrast, nonprofits focus on advancing their mission and must demonstrate financial accountability to donors and stakeholders. This is where fund accounting comes in, allowing financial controllers of nonprofit organizations to manage and report financial resources according to their designated purposes.

In this complete guide, we’ll explore what fund accounting is, covering the basics and best practices you and your finance team need to know.

We’ll answer common questions and provide practical insights to help you understand how fund accounting works.

Fund accounting definition

What is fund accounting?

Fund accounting is a specialized method of accounting used by nonprofits, charitable organizations, religious groups, and government entities to manage and track financial resources.

Funds must be used in line with their intended purpose.

Nonprofits need to know how much money they have received and spent and what’s left over across different areas of their organization.

Fund accounting helps nonprofit organizations track finances accurately, produce reliable reports, and make informed decisions.

What is a fund?

A fund is a distinct area within your nonprofit organization that needs to be tracked separately from other finances.

Think of it as a small, independent part of your organization with its own assets, liabilities, equity, income, and expenses.

Examples of funds include designated funds, restricted funds, unrestricted funds, grants, and specific campaigns.

What types of organizations need fund accounting?

Key types of organizations using fund accounting include nonprofits, government bodies, educational institutions, and religious institutions.

Nonprofit organizations

Nonprofits, like charities, foundations, and healthcare institutions, rely on multiple funding sources, including donations, grants, and scholarships.

Each of these funds comes with specific restrictions or purposes.

For instance, a nonprofit may need to track specific grants with deadlines or conditions, and fund accounting helps ensure that the money is used as intended.

Government bodies

Government entities, from local to federal levels, rely on fund accounting to manage taxpayer money and keep finances transparent.

These organizations handle everything from operational funds to capital projects.

Fund accounting helps governments allocate money properly across different project initiatives, preventing overspending and ensuring compliance with strict regulatory standards.

Many governments streamline this process using accounting software for government and public benefit organizations, simplifying financial management and reporting.

Educational institutions

Colleges, universities, and K-12 schools also often use fund accounting to manage a variety of income sources, such as tuition, donations, and grants.

Educational institutions often juggle complex endowments, scholarships, and operational costs.

Fund accounting ensures that funds are used for their intended purposes—whether that’s for academic purposes, research, or student services.

Religious institutions

Churches and other religious organizations also use fund accounting to track donations allocated to different purposes.

For example, one fund may be dedicated to building maintenance, while another supports outreach programs.

Fund accounting ensures each dollar is used as intended, from keeping the lights on to funding philanthropic work in the community.

Why is fund accounting important for nonprofits?

Fund accounting is crucial for organizations, especially nonprofits, because it ensures financial accountability and transparency. Here’s why it matters:

Proper use of funds:

Nonprofit fund accounting helps organizations keep a tight grip on where the money is going.

For instance, if an organization has $25,000 allocated for a youth program, $15,000 for community outreach, and $10,000 for a building renovation, each fund must be spent only on its designated purpose.

If a grant covers $20,000 of the youth program, the remaining $5,000 can be allocated from other sources.

This level of tracking is only possible with a system like fund accounting, which focuses on fund allocation.

Compliance with nonprofit regulations:

Fund accounting helps nonprofits meet legal requirements and maintain their tax-exempt status by ensuring accurate reporting.

For example, 501(c)(3) organizations must submit Form 990 annually to report how funds are used.

Fund accounting allows nonprofits to easily provide the detailed financial information required for this and other compliance reports, including adherence to FASB (Financial Accounting Standards Board) standards.

Building trust with donors

When people donate to a cause, they want to know that their contributions are making a difference.

Fund accounting allows nonprofits to honor any restrictions placed on donations.

For instance, if a donor gives $5,000 specifically for a scholarship program, fund accounting ensures that money is used only for scholarships.

This transparency helps build and maintain trust with donors, encouraging ongoing support.

Financial transparency and planning:

Fund accounting gives organizations a clear view of how much money is spent on different areas, such as program services, fundraising, or administrative costs.

This helps nonprofits make more accurate budgets and financial plans to ensure they have enough resources to continue operating effectively.

Knowing the financial status of each fund also allows organizations to set aside reserves and prepare for unexpected expenses.

Managing liquidity and resource allocation:

Organizations often have different levels of liquidity across funds.

For example, restricted funds, grants, or endowments may not be readily available for immediate use, whereas unrestricted operating funds can cover urgent needs.

Fund accounting helps nonprofits identify which funds are accessible and which are less liquid, allowing them to plan accordingly.

Fund accounting basics: 5 key principles

Fund accounting has many moving parts, but by keeping these five key principles in mind, you’ll have a solid foundation to manage your organization’s finances effectively and ensure compliance with legal requirements. Here are the basics of fund accounting:

1. Accountability and transparency

Fund accounting is built on the principle of accountability. It’s designed to ensure that nonprofit organizations use donations and grants precisely as directed by donors, foundations, or government agencies.

It also promotes transparency by clearly tracking how every dollar is received and spent. This helps nonprofits comply with legal and donor requirements, building trust with stakeholders like donors and regulatory bodies.

When you use nonprofit accounting software to track your funds, you demonstrate that your organization is a responsible steward of the financial resources entrusted to you.

2. Separation of funds

In fund accounting, it’s important to keep each fund separate.

This means tracking the money coming in, what’s being spent, and the remaining balance individually.

For example, if your nonprofit raises money for a new community center, that money stays separate from your operating budget.

Keeping funds apart ensures they’re used as intended.

Common fund types include operating funds for day-to-day expenses, capital project funds for major initiatives, and restricted funds for specific purposes.

3. Fund restrictions

In fund accounting, one of the main principles is distinguishing between restricted and unrestricted funds.

There are three types to bear in mind:

1. Unrestricted funds: These are donations or financial resources that can be used however the organization sees fit. The flexibility allows nonprofits to cover everyday expenses like salaries, rent, utilities, and other operating costs. The fund allows the nonprofit to respond to unexpected needs, invest in growth opportunities, and support areas lacking funding.
2. Temporarily restricted funds: These are donations or grants that can only be used for a specific purpose or after certain conditions are met, like using the funds for a particular project or after a set time. Once restrictions are fulfilled, the funds become “unrestricted” and can be spent more freely.
3. Permanently restricted funds: The organization can’t spend these donations. Instead, the money is invested, and only the income (like interest or investment returns) can be used to support the organization. The original donation stays untouched, usually to provide long-term financial support, like an endowment.

4. Fund balances and reserves

Nonprofits need to know what money they have left in a fund account that can be used in the future.

They need to maintain reserves in key funds to ensure long-term stability.

Think of reserves as a rainy-day fund that can help the organization stay steady during uncertain times or cover unexpected costs.

It’s worth regularly checking your fund balances and reserves and having a reserve policy in place so your nonprofit can stay financially healthy and keep delivering on its mission, even when things get unpredictable.

5. Reporting requirements

Tracking where fund money goes and what’s left is important, but nonprofits also need specific reports to demonstrate their fund accounting and show accountability.

One essential report is the Statement of Activities, which shows income and expenses for each fund.

Other reports, like the Statement of Financial Position, show the organization’s overall health by listing assets, liabilities, and fund balances.

Compiling these complex reports manually can be a headache—that’s where automated tools come in.

With accounting software for foundations and philanthropic charities, you can streamline fund reporting, automatically generate GAAP financial statements, Form 990 submissions, and more, ensuring compliance and transparency.

Breaking down the types of funds in fund accounting

In fund accounting, organizations divide their money into funds to ensure it’s used for the right purpose.

Nonprofits, educational institutions, and other mission-driven organizations use three main fund types:

Operating funds

Operating funds cover everyday expenses, like staff salaries, rent, and utilities.

They’re typically funded by unrestricted donations or general revenue. While they can be used freely, they still need to be tracked.

Restricted funds

Restricted funds are donations or grants given for specific purposes.

For example, a donor might give money for a new building.

These funds must be used exactly as the donor intended.

Temporarily restricted funds

These are like restricted funds but have a time limit.

For example, a grant might need to be used within a year.

Once the time limit is up, the money can be used for other purposes.

Endowment funds

Endowment funds are meant to last long-term.

The original donation (called the principal) is invested, and the organization can only spend its income.

This ensures that the money will continue supporting the organization for years.

Other special funds

Depending on the organization, additional fund types might be used:

• Capital project funds for large-scale projects like construction.
• Debt service funds to pay off loans or bonds.
• Special revenue funds for specific projects or services, often funded by grants or user fees.
• Permanent funds that support a cause indefinitely, using only the income from investments.

The fund accounting process: 5 steps to follow

Fund accounting for nonprofits typically follows a structured process. Here are the key steps involved:

Step 1: Budgeting and planning

Before recording anything, organize funds and set clear budgets to ensure resources are allocated correctly for upcoming projects or needs.

Step 2: Recording transactions

Track all income and expenses, making sure each transaction is assigned to the right fund for accuracy.

Step 3: Tracking fund usage

Regularly review fund balances to see what’s left, ensure money is being spent as intended, and keep spending within budget.

Step 4: Generating financial reports

Regularly create reports, like the Statement of Activities, to keep track of each fund’s performance and ensure you’re meeting legal and donor requirements.

Step 5: Reviewing and auditing

Double-check all transactions and balances for accuracy at the end of each accounting cycle.

This step often includes a review by stakeholders or auditors to ensure everything is in order.

Real-world fund accounting examples

Fund accounting helps organizations keep their finances organized and accountable across different sectors.

Whether it’s nonprofits, government agencies, or universities, each uses fund accounting to ensure funds are tracked for the right purpose.

These examples will show how different organizations put fund accounting principles into action to stay on track and use their resources responsibly.

Nonprofit: The American Red Cross

The American Red Cross uses fund accounting to make sure donations are spent where donors intended.

For example, funds raised for disaster relief are tracked separately from those for health services, ensuring every dollar goes to the right cause.

Government: The City of San Francisco

San Francisco keeps its finances organized by using fund accounting for different needs, like funding road repairs or health programs.

This approach helps the city stay accountable and ensures public funds are spent responsibly.

Education: Harvard University

Harvard’s endowment fund is carefully managed to support scholarships, faculty salaries, and campus upkeep.

The university invests the principal and uses only the earnings to fund important programs, preserving the endowment for future generations.

Fund accounting best practices

When it comes to fund accounting for nonprofits, it’s crucial to ensure accuracy, transparency, and compliance.

By following a set of best practices, your organization can effectively manage its financial resources, maintain donor accountability, and meet legal requirements.

Below are some actionable strategies to help you implement strong fund accounting practices and ensure long-term financial health.

Categorize funds based on their purpose

When separating funds, ensure each one is designated clearly, such as operating, restricted, or capital project funds.

For example, donations for a specific capital campaign shouldn’t be mixed with general operating funds.

Choose fund accounting software to automate this process and generate reports to track balances.

Implement strong internal controls

Establishing strong internal controls protects your organization from errors and fraud.

This involves setting up procedures for approvals, separating duties (e.g., the person recording transactions shouldn’t be the same one approving expenses), and conducting regular audits.

Internal controls also ensure compliance with regulations like FASB standards or IRS Form 990 reporting for nonprofit organizations.

Keep detailed records

Accurate records are crucial for compliance and transparency.

Each donation, grant, or revenue source should be recorded and allocated to the appropriate fund.

This means keeping detailed records of income, expenses, and fund balances.

Use your chart of accounts to ensure every transaction is tracked properly.

Follow standard reporting guidelines

Use consistent reporting standards like GAAP or FASB to create clear and comparable reports.

Reports like the Statement of Activities and the Statement of Cash Flows provide insights into how funds are managed while meeting regulatory requirements.

Use fund accounting software

Accounting software for nonprofits can help you automate tasks like tracking multiple funds, generating specific reports, and ensuring compliance.

For example, tools like Sage Intacct offer templates for Form 990 submissions and FASB-compliant reporting, saving time and reducing human error.

Consider outsourcing for expert support

If your team doesn’t have the expertise or capacity to manage fund accounting, outsourcing to professionals can help.

Dedicated fund accounting firms ensure your financial records meet all compliance and regulatory standards, like IRS regulations for nonprofit tax-exempt organizations.

Fund accounting vs. traditional accounting

Fund accounting and traditional accounting both aim to provide accurate records of financial information.

However, because they serve different types of organizations or businesses, which mean there are nuances to their purpose and goals.

Here are the key differences:

Organizational focus

Fund accounting is designed for organizations that need to track resources with specific purposes.

It emphasizes accountability and transparency by separating funds, such as grants and donations, to ensure compliance with donor restrictions.

On the other hand, traditional accounting is used by for-profit businesses.

It focuses on measuring the commercial organization’s overall financial performance and profitability.

Resource allocation and flexibility

In fund accounting, resources are divided into distinct funds, each within its own restrictions and requirements.

For example, a nonprofit must manage restricted donations separately from operating funds.

Comparatively, traditional accounting allows for more flexibility in reallocating resources as financial resources aren’t typically restricted.

Reporting differences

Fund accounting dictates that nonprofits need to produce specialized reports like the Statement of Activities, which shows fund-based financial information.

This approach provides detailed insights into individual funds and ensures that money is used according to its designated purpose.

Traditional accounting focuses on consolidated financial reports, such as the Income Statement, to present the company’s overall financial status.

Regulatory and compliance requirements

Nonprofit accounting standards impose specific reporting requirements, including filing Form 990 for annual tax returns and complying with FASB legal obligations.

In contrast, traditional accounting follows general frameworks like GAAP and must comply with SEC regulations for public companies to ensure accurate financial disclosures.

Emphasis on transparency vs. profit

Fund accounting prioritizes the accountability and reporting of restricted and unrestricted funds, ensuring donors and stakeholders can see exactly how resources are utilized.

However, traditional accounting focuses more on profitability metrics and shareholder value than tracking funds for specific purposes.