Nonprofits also have a distinct system for managing their finances, known as fund accounting. In this guide, you’ll learn all you need to know about how this process works and why it’s important for your organization. We’ll cover:
- Fund Accounting FAQ
- The Nonprofit Fund Accounting Categorization System
- Fund Accounting Best Practices
With the right tactics, technology, and assistance on your side, fund accounting can be more than just a set of requirements to follow—it’ll become a vital tool to help your nonprofit further its mission. Let’s get started!
Fund Accounting: Frequently Asked Questions
To clarify this complex concept, we’ve answered a few of the most common questions about fund accounting below.
What is fund accounting?
Fund accounting is a method of managing finances designed for tax-exempt organizations. Generally speaking, it tracks which funds are designated for various programs and operations and how much money is allocated to each activity.
Traditional accounting (the method businesses use) focuses on turning a profit by tracking revenue from sales of products and services. However, fund accounting is primarily concerned with accountability rather than profitability, since your organization can’t turn a profit by definition. Your financial management structure should help you follow through on your commitments to donors as you fund your mission.
Why is fund accounting important?
Besides the ultimate purpose of helping you make sure you have the resources you need to drive your mission forward, fund accounting has many benefits for nonprofits like yours. These include:
- Maintaining compliance. When your nonprofit files its annual tax return via IRS Form 990, reviewers will expect you to follow the principles of fund accounting in your financial management activities and base your continued tax exemption (in part) on that factor. This system also makes it easier for your organization to align with other financial standards, particularly the Generally Accepted Accounting Principles (GAAP).
- Promoting transparency. In addition to governing bodies wanting to know how your nonprofit uses its funding, donors, grantmakers, and other stakeholders also expect you to report these activities honestly. This is especially true for funders who have designated their contributions to specific initiatives, since they need to know your organization has followed through on your promises to them.
- Boosting your organization’s reputation. Honoring commitments to donors and grantmakers doesn’t just strengthen your relationships with those individuals, although doing so is important for gaining their long-term support. Rather, demonstrating proper management of funds affects your entire community’s perception of your nonprofit, since everyone can be confident that you’re using your resources wisely and care about your supporters.
- Improving resource allocation. Fund accounting is also useful internally because it helps you see how much funding is available for various initiatives. That way, you can more effectively finance all of your programs and operational activities without accidentally misappropriating donor-designated funds.
As of 2024, 67% of nonprofit supporters believe it’s essential to trust the organizations they contribute to, but only 22% say they highly trust nonprofits. Fund accounting is just one piece of the puzzle for improving donor trust, but it’s a critical one because of its benefits for internal decision-making and especially compliance.
What types of organizations use fund accounting?
Nearly all tax-exempt organizations use fund accounting to manage their finances, including:
- Traditional 501(c)(3) nonprofits
- Private, public, and family foundations
- Local, state, and federal governments and their agencies
- Professional and trade associations
- Faith-based organizations (houses of worship, independent ministries, etc.)
- Educational institutions, including both public and private K-12 schools and universities
- Hospitals, health systems, and other healthcare organizations
While there may be nuances in how these organizations set up their accounting systems and report on their funding, they all use the same basic categorization model to remain accountable as they manage their finances.
The Nonprofit Fund Accounting Categorization System
The basis of a fund accounting system is dividing all of your nonprofit’s revenue into three categories based on what conditions (if any) the contributing individual or organization has placed on its use. Let’s look at each category in more detail.
Permanently Restricted Funds
Generally speaking, restricted funds are nonprofit contributions that a funder has designated to be used for a specific purpose. In some cases, those designations hold in perpetuity, meaning your organization would categorize the funds in question as permanently restricted.
Endowments are the most common type of permanently restricted nonprofit contribution. They generally work as follows:
- One or more donors contribute a large amount to your organization and earmark it for an endowment fund.
- Your nonprofit places that money (known as the principal) in an investment account, and in most cases, you’ll never spend that money directly.
- The principal generates interest, which your nonprofit then uses to fund an ongoing initiative that you’ve agreed upon with the endowment donor(s).
Despite their specificity, endowment funds can be extremely beneficial for many types of organizations that need resources for long-term projects. Universities often have endowed scholarships and fellowships, hospitals may use endowment funding to conduct research on complicated health conditions, and a church might even start an endowment to support its missions and outreach work. Donors who contribute permanently restricted funds typically want to support these activities for years to come since they’re passionate about that area of work.
Temporarily Restricted Funds
Besides endowments, most donor-designated contributions to your nonprofit aren’t restricted indefinitely. Instead, they’re temporarily restricted, meaning they’re bound by a specific purpose or time period. Once the purpose is fulfilled or the time expires, the restrictions no longer apply to any resources that remain.
Some examples of temporarily restricted contributions include:
- A major gift to a capital campaign that’s raising money for a building project, so the gift is restricted until the project is finished.
- A grant that funds a new program launch and can only be used for that program for the first three years of its existence.
- A corporate sponsorship package that covers a set amount of upfront costs of hosting a fundraising event until the conclusion of said event.
Whenever possible, you should use the full amount of a temporarily restricted contribution for its intended purpose, which is why it’s important to budget carefully for initiatives like the ones mentioned above. However, if things don’t go to plan and you have leftover funds (for instance, if the building project your capital campaign funded is completed under budget), reach out to the funder to see if they want the rest of their contribution to be returned to them, support another initiative of their choice, or go toward any area of your budget that needs additional funding.
Keep in mind that donor-imposed funding restrictions—whether temporary or permanent—are legally binding. If your nonprofit misallocates these funds (even by accident), contributors have the right to sue your organization, plus you might incur fines from the IRS. Long story short, track restricted funds carefully by using fund accounting!
Unrestricted Funds
On the other hand, unrestricted funds have no designations attached. Your nonprofit can put them toward any expenses you incur, whether they’re related to mission-driven programs and initiatives or support the administrative and fundraising needs that contribute to your overhead.
Here are a few examples of nonprofit contributions that are typically unrestricted:
- Small and mid-sized individual donations, both monetary and in-kind
- Corporate giving contributions from programs other than sponsorships (e.g., employer matching gifts, volunteer grants, or payroll donations)
- Investment returns that aren’t tied to endowments but instead come from vehicles such as CDs, Treasury bills, bonds, and mutual funds
- Earned income streams like membership dues, merchandise sales, event ticketing, and service-related revenue (e.g., animal shelter adoption fees or museum admissions).
Remember that these funds are unrestricted because their contributors didn’t designate them for specific purposes. If your organization internally allocates certain funds and informs donors about it (e.g., advertising that all of the revenue from your annual gala will go toward a new program launch), they’re still considered unrestricted, and the designation isn’t legally binding. However, it’s still in your best interest to use those funds as promised to build trust with your supporters.
Fund Accounting Best Practices
Understanding different types of funding restrictions is just the first step in effective fund accounting. Here are a few other best practices to implement to make this system work for your nonprofit:
- Pursue restricted contributions strategically. Any revenue you try to bring in that may be restricted should align with your nonprofit’s overarching goals and biggest funding needs. Focus your cultivation efforts on prospective major donors and corporate sponsors who would be able and willing to support key initiatives, and only apply for grants that closely match your mission and programming.
- Budget with fund accounting principles in mind. When creating your nonprofit’s annual operating budget, allocate restricted funds first so you have a better understanding of the available funding for each activity. Then, make note of all designations in the budgeting document to ensure any last-minute adjustments don’t lead to misappropriation.
- Separate out restricted funds in internal reports. Financial statements like your annual balance sheet and statement of activities should include separate lines for restricted and unrestricted net assets. This will make it easier to report designated gifts on your Form 990 and to show interested stakeholders how you’ve used these funds.
- Leverage fund accounting software. Many nonprofits track their finances in spreadsheets when they first get started, but switching to specialized accounting software once it’s in your budget to do so is essential for fully implementing a fund accounting system. You can either choose a nonprofit-specific accounting platform that has restricted fund tracking built in or manually configure it in a generalized accounting solution—either way is fine, as long as the software you choose supports fund accounting in some way.
The best way to ensure proper fund accounting at your organization is to partner with nonprofit financial professionals like the team at CFO Leverage. Because we work exclusively with exempt organizations, we have extensive experience with restricted fund management and other common nonprofit-specific financial challenges. Whether you’re looking for everyday bookkeeping support, higher-level financial strategy development, or other custom financial services, we can provide expert support at an affordable rate!
Wrapping Up: Additional Resources on Nonprofit Accounting
Fund accounting may seem complex at first, but it’s essential for furthering your mission and honoring your commitments to the supporters who make that possible. Use the tips and guidance above to get started, and remember that our experts at CFO Leverage are here to help anytime you may need it.
For more information on nonprofit accounting, check out these resources:
- Gifts-In-Kind aka Non-Cash Donations. Discover how to manage and report gifts of goods and services, which can also be tricky but highly beneficial to your work.
- Cash Management in a Nonprofit. Dive deeper into some of the factors that make nonprofit financial management unique and tips to effectively steward your resources.
- Audit Testing Explained: How Auditors Evaluate Your Nonprofit’s Finances. Learn what to expect if your nonprofit chooses to conduct an independent financial audit.
