Even though nonprofits don’t operate with a profit-driven mindset, they still need a way to track finances. Unlike other for-profit companies, charitable organizations use a specific method called “fund accounting” to track and manage their money.
The thing is, fund accounting is a bit more complex than traditional accounting. And when nonprofits report an annual average of $2.6 trillion in revenue in the U.S. alone, they need to be very careful in how they manage, disperse, and report on funds accurately, especially when they're designated for particular projects or programs.
Without a good handle on your fund accounting, you’re looking at revenue issues, noncompliance, grant mismanagement, and more.
If you want to make sure your nonprofit finances are precise, well-managed, and up-to-date, below we'll get into everything you need to know about fund accounting.
If you're not a reader, I also break it all down for you here in this video:
What is fund accounting?
At their core, nonprofits function financially in ways different from a typical for-profit business. Because of this, they need distinct accounting practices. This is where fund accounting comes into play.
Fund accounting tracks and manages financial resources to ensure they’re used for specific purposes or activities. This system allows nonprofits to track funds, see how they’re managed, and where they are ultimately spent.
As the name might suggest, fund accounting operates by separating financial resources into different groups called funds. Several types of these groups are often used in nonprofit fund accounting (which we’ll dive into later). There are also many functional reasons nonprofits use fund accounting and many benefits when used correctly.
Why 501(c)(3) organizations need fund accounting
If you’re sitting there thinking, “Why would I have to separate funds if they’re all going to the same cause?”, the simple answer is, because they might not be. Let’s take a look at this and other reasons why fund accounting is so important:
- One reason nonprofits use fund accounting methods is that donations and grants can come with specific conditions. That means you're responsible for ensuring that those funds are used properly within your organization.
- Fund accounting increases accountability with your stakeholders, both internal and external. Since these accounting methods dictate what money goes where, you can easily show board members and donors alike that you're being responsible with the funds you receive.
- Fund accounting helps you better organize your financial resources. As you divide up certain revenue streams, you can clearly see where you might need to dedicate more funding and areas you can pull funding from, so long as those funds are unrestricted.
Understanding different fund categories
By now, it’s clear that not every dollar that comes into your organization is for unfettered use. That's because funds break down into three distinct categories, each with its own set of rules.
1. Unrestricted funds
Unrestricted funds can be used for any purpose within your nonprofit. This can include salaries, administrative costs, or fundraising efforts, for example.
Unrestricted funds tend to make up the majority of nonprofit revenue, coming from small to medium donations, fundraising events, membership dues, merchandise sales, or corporate giving.
Since there is no set rule as to where you can use this money to support your nonprofit mission, you have a bit more flexibility in using these funds to support operations.
2. Restricted funds
On the other hand, restricted funds are financial resources meant for a specific purpose. To keep this money, ensure compliance, and increase your chances of receiving additional funds in the future, you must use this money for its intended purpose, nothing else. Restricted funds typically come from grants, large-scale donations, or corporate sponsorships.
Permanently restricted funds can also involve deferred payments, meaning you receive the money but cannot spend it until a certain point.
3. Temporarily Restricted Funds
In some cases, you’ll receive funds that come with donor-specific conditions, but those conditions will be lifted after a certain amount of time or certain criteria have been met. These often come in the form of board-designated funds, program-specific funds, and capital project funds.
Fund accounting versus traditional accounting
Fund accounting is an entirely different ball game compared to regular, for-profit business accounting. Some of those key differences include:
The components of fund accounting
There are four main financial tools that you'll use to manage your nonprofit financial health within fund accounting. Those are your:
- Chart of accounts — This is the labeling system that keeps track of every grant, donation, and expense you have so that you can easily track all your money.
- Operating budget — This outlines your operating expenses and expected revenue and shows what you’re looking to achieve over the planned time period (monthly, quarterly, or annually).
- Financial statements — Named slightly different from for-profit businesses, your nonprofit will use a statement of financial position, a statement of activities, and a statement of cash flow.
- Monthly, Quarterly, or Annual Reports — You’ll pull annual reports from donors, board members, and tax and regulatory agencies that demonstrate how you’ve used your financial resources.
These financial tools all use data based on your accounting activity, so you must record fund activity carefully.
How to record fund usage
To maintain compliance and ensure you're using funds appropriately, you need to record each transaction as it relates to the fund it's in. This is especially important for restricted funds that will require proof of appropriate usage.
The fund lifecycle goes like this:
1. Set up your chart of accounts
Gather all the data about your assets, liabilities, net assets, revenue, and expenses. Enter them into your COA, labeling everything using the Unified Chart of Accounts’ codes to keep everything organized and in line with industry standards.
Here’s a hint: Use a template to put together your COA and make your life easier.
2. Identify what funds you need
As a nonprofit, you’ll need to assign any money received to the correct funds within your nonprofit chart of accounts. When you receive funding—whether it be a donation, grant, or otherwise—make sure you assign it to the correct category.
3. Record transactions properly
For every transaction you make using various funds, you need to clearly record the amount and purpose of those funds. This typically involves debiting the fund’s expense account while crediting the fund’s asset account.
4. Track your fund balance
Don’t lose track of what you’ve used and what assets you have left. Track your fund balance by adding up all the expenses recorded within the fund and subtracting that number from the total amount you received to begin with. Do this on a regular basis to stay on top of your finances.
5. Appropriately release funds
When you’re working with restricted funds, you have to take extra steps to use that money. To release restricted funds, you’ll have to add a journal entry into your ledger that decreases the temporarily restricted funds balance and increases your unrestricted fund balance.
This is incredibly important to get right if you want to maintain compliance.
6. Reconcile your accounts
At least once a month (more often is better), compare your chart of accounts with your actual bank accounts to ensure that the funds you have available match the amounts you have recorded. If you find any discrepancies or things aren’t matching up, you’ll have to go through your financial activity until you find the errors.
7. Generate fund-specific reporting
As a nonprofit, you’re required to provide reporting to a number of different regulatory and government agencies. To avoid any issues during nonprofit audits, you’ll want to put together reports that clearly outline each fund and meet the unique reporting requirements for grants.
What to avoid in fund accounting
Even more so than traditional accounting, fund accounting has a lot of moving parts. Because of that, the methods used to track and manage various funds are very nuanced and can cause a lot of confusion, especially as you grow and receive more funds.
To that end, there are a few common mistakes you should avoid making:
- Having too many funds and categories — Don’t overcomplicate things. Keep your funds simple, based on their overall intended use or conditions.
- Mixing funds — You need to keep restricted and unrestricted funds separate. Don’t ever keep these funds in the same account.
- Unclear documentation — Chaotic documentation leads to chaotic financial operations. Make sure every activity you record is easy to understand and tells an accurate picture of your fund usage.
- Only focusing on individual funds — Don’t get lost in the weeds of individual funds. Look at the bigger picture of what those funds all add up to as they support your mission.
Worried you’ll make a costly mistake? Don’t panic—we have a solution.
Get a real-time look at your nonprofit financial data
As vital as fund accounting is for your nonprofit, it’s far from a simple process. Finding the data needed to inform these accounts can be hard enough, never mind recording transactions and pulling reports for donors and compliance agencies.
At Hiline, we provide finance as a service that's tailored to meet the unique fund accounting needs of nonprofits. From bookkeeping and finance to tax and HR, we've got you covered. With your accounting needs in good hands, you can focus on you’re real goal—making a difference in the world.
When it comes to your finances, we’ll take it from here. Contact us today to get started.
Sign up for our newsletter.
