What sets nonprofit organizations apart from for-profit businesses? The answer is simple. Each has its own criteria for financial success.
For-profit organizations focus on profitability, whereas nonprofits use fund accounting to focus on accountability. Success for nonprofit organizations is determined by fulfilling its mission. To accomplish this, nonprofits must raise money and be accountable to funding sources.
Contrary to a for-profit, a nonprofit has two bottom lines. One is to fulfill their stated mission while the other one is having the necessary funding to support their mission.
Nonprofits are held to different standards than for-profits and are required to separate revenue sources into categories or funds. This allows nonprofits to demonstrate accountability rather than profitability.
Fund accounting identifies revenue sources and provides transparency for the organization. It shows how revenue is being spent and determines if the revenue is being used for its specific purpose.
When managed properly, fund accounting can reveal areas of strength and weakness. A fund is like a separate company within your organization. Each fund has its own self-balancing set of books to track assets, liabilities, revenue, expense and fund balances or net assets. Revenue earned by nonprofits has different characteristics than for-profit businesses.
3 Fundamental Types of Funds
1. Unrestricted Fund
There are no restrictions placed on this type of fund. The nonprofit can use the revenue as it sees fit. Restricted gifts, or gifts with strings attached, fall into two categories known as the gift instrument, which is the document that determines how the donated funds will be used. This could be an award letter from a foundation or a letter from an individual donor.
2. Temporarily Restricted Fund
These funds have time restrictions.The donation can be used for a specific purpose for a specific period or must support a specific program or campaign like a capital fundraising campaign. Examples include purchasing computers for a classroom, or completion of a building project.
3. Permanently Restricted Fund
These funds never expire. However, there is a catch. Only the income earned by the assets can be used. The original gift must be kept intact forever or for a designated period of time. For example, a permanently restricted fund may go into an endowment that supports a particular activity or the organization in general.
Subcategories Identify Funds for Specific Purposes
There are subcategories of funds that can be part of the nonprofit’s overall financial makeup, such as Board Designated Funds. These are a subcategory of unrestricted funds. It is established when the board transfers or separates part of the unrestricted fund into a fund intended to use for a specific purpose.
For example, let’s say you set up a Fixed Asset Fund to track all buildings, furniture, fixtures and equipment.
In this case, the board might want to separate these assets from the unrestricted fund. This way the unrestricted fund can clearly represent the activity of the current program use. This is an arbitrary decision by the board.
Fund Accounting Basics
Fund accounting focuses on accountability and proper stewardship. This is essential for nonprofit organization compliance of government regulations and requirements.
Most importantly, fund accounting enables nonprofits to manage revenue received by funding sources by monitoring the restrictions typically associated with the revenue. By separating revenue into specific funds, it prevents misuse of funds. Each fund has its own revenue and expense report, its own excess or deficiency calculation, and its own balance sheet.
A fund accounting system groups funds into three categories of net assets: unrestricted, temporarily restricted, or permanently restricted, which nonprofits can use to satisfy GAAP and FASB 116/117 requirements and easily report on the breakdown of net assets on IRS form 990.
Common Mistakes Made in Fund Accounting
One of the biggest mistakes nonprofits make when it comes to fund accounting is to segregate assets by fund. It is not necessary to create separate bank accounts for the cash attributable to a fund, especially when all of the organization’s cash is in a single bank account. The only thing that comes out of this is extra work.
Another popular mistake is to set up a fund for every program, grant, mission, project, or other activity that the nonprofit operates. This is especially true for churches and missionary organizations.
For example, a church may set up a separate fund for every ministry such as women’s, men’s, children’s, alter guild, flowers, refreshments, bible study, etc. Some nonprofits tend to set up separate funds for each of their grants because they think it is required.
A better way is to track all this activity by program codes within a fund. If created properly, a program classification within a fund can easily track and designate revenue and related expenses for specific activities. These separate areas are referred to as functional areas and fall under three categories: management and general, fundraising, and program.
Fund Accounting Rules for Donations
It is up to the donor to decide on whether a donation is restricted or unrestricted. They can specify their wishes by a letter or through an agreement with the nonprofit.
When it comes to grants from foundations, these are typically restricted to a particular program or purpose. Usually the restrictions are spelled out in the documentation for the grant award.
Nonprofits must be open when asking for donations from donors. They may ask for unrestricted funds when soliciting donors by email or direct mail. A clause will clearly state this on the donation form or in the gift acknowledgement. There are exceptions to this when asking donors to give to capital campaigns, a building fund or a scholarship fund.
This is particularly important when it comes to donors who specify donating for a specific purpose only to find out that the charity used their gift in an unrestricted way.
To avoid this, a good suggestion is to give donors a choice of designation at the time of the donation. In this way a donor can choose their option among several options. If a donor specifies the donation be used for a specific purpose and the nonprofit does not comply, then the donor can demand a refund and legal action if needed and report the charity.
In order to maintain nonprofit status, the objective is to keep a clean image in the public eye. By implementing fund accounting methods, your organization can become compliant and accountable to funding sources.
This article was generously contributed by Joseph Scarano of Araize. Thank you, Joseph!
ABOUT THE AUTHOR Joseph Scarano is the CEO of Araize, Inc., developers of cloud-based FastFund Online Nonprofit accounting, fundraising and payroll software solutions to help your nonprofit become more transparent, accountable and sustainable.