Should Your Nonprofit Consider Using Fund Accounting?

Depending on the nature of your not-for-profit organization, there's more than one accounting method to follow. One option is fund accounting, which promotes transparency and can help nonprofits fulfill donor commitments. Fund accounting involves segregating revenue into distinct funds, or "buckets," depending on the source and potential restrictions on it. Let's take a look at when and how fund accounting is applied.

Types of Funds

The key principle in fund accounting is assigning a particular fund as each activity occurs. For example, when your organization receives a donation, it typically records key details, such as the donor's name, and other vital information, such as the amount and date of the donation. Fund accounting takes this process a step further by

designating the donations to a specific fund — such as a general, capital investment or endowment — based on the donation's intended purpose.

As donations are separated according to their purpose, they're accounted for individually. Each fund has its own set of books and records, and may require different bank accounts. Typically, nonprofits have three main types of funds:

1. ‍Permanently restricted. As the name implies, permanently restricted funds can be used only for a specified purpose. This could include funds designated only for a permanent endowment.‍
2. Temporarily restricted. Donations to this account are restricted to a specific purpose, but only on a temporary basis. Restrictions might involve a set period of time (for instance, 10 years from the donation date) or the achievement of a goal, such as raising $100,000 in additional donations.‍
3. Unrestricted. Although the use of permanently or temporarily restricted funds isn't mandatory, every nonprofit must offer at least one unrestricted fund — even if it means moving all donations into a single pot.

The use of fund accounting encourages compliance with donor stipulations and also generally provides transparency. Most donors and grant makers want to know how their money will be used and to see that you're complying with any restrictions. Nonprofits that don't adhere to restrictions risk lawsuits and revocation of their tax-exempt status.

Maximizing Benefits

Fund accounting isn't always the best fit for every organization. It can require more time and expertise to execute than standard accounting methods. Smaller nonprofits with narrow missions may benefit from having one simple, unrestricted fund. But large organizations that don't have any restricted funds may want to use fund accounting to provide greater insight into their use of contributions. For nonprofits managing restricted funds, fund accounting can help reduce legal risks.

Depending on the type of your organization, you might consider taking the following steps to maximize the benefits of fund accounting:

• ‍Carve out niches. Establish separate restricted funds for donations or groups of comparable donations. For instance, a large donation or significant bequest may warrant its own dedicated fund.‍
• Limit the number of unrestricted funds. Avoid creating too many narrow unrestricted funds that can cause administrative "logjams." For example, if your organization facilitates food drives within your state, you don't need to create a separate fund for every community or county.‍
• Guide donors effectively. Donors may be interested in supporting your cause in a specific way but may not have a particular program in mind. Educate them about restricted funds you've already established to see if any meet their needs.‍
• Honor requests or say "no." No nonprofit wants to turn down a donation, but you must ensure you can comply with all donor restrictions before you accept a restricted contribution. Failing to do so could cost time, money and your organization's reputation.‍
• Keep it simple. Fund accounting requires you to keep separate books and records for activities. But you don't have to physically separate all assets. Setting up separate bank accounts for different funds may create more hassle than benefit.‍
• Demand expertise. Off-the-shelf software may not suffice for fund accounting needs. Consider customized software or engage professionals experienced in nonprofit accounting to handle the work.

Optimal Method

Is fund accounting right for your organization? Talk to your advisors to determine optimal accounting approaches, given your nonprofit's size, mission and complexity.