What Is Fund Accounting? (With Importance And How It Works)

By Indeed Editorial Team

Published 27 July 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Fund accounting is an accounting system that non-profit organisations (NPOs) and government agencies use to ensure the accurate expenditure of financial resources. It helps NPOs to maintain a record of fund allotment and ensure that organisations justify the utilisation of these funds. Learning about fund accounting can help you understand the patterns of how an organisation utilises money and why it emphasises accountability. In this article, we answer the question, "What is fund accounting?", review how it works and discuss its importance, along with listing organisations that use it.

What Is Fund Accounting?

The answer to the question, "What is fund accounting?", is that it is a system of accounting that ensures organisations are using funds productively. This accounting system emphasises accountability over profitability, helping NPOs to work towards their mission. Fund accounting utilises good internal control and reporting systems to develop reports that present an organisation's financial standing. Fund accounting systems help trustees of an organisation to realise their legal commitments to utilise the organisation's funds in compliance with its guidelines.

Related: How To Become A Fund Accountant (Plus Primary Duties)

Types Of Funds In Fund Accounting

Below are the different funds in fund accounting:

Unrestricted funds

An NPO may use unrestricted funds for any of the organisation's purposes. Referred to as general funds, the organisation may use these funds for operational expenses, like rents, utilities or salaries. Donations that an organisation collects are unrestricted funds unless donors specify the purpose of their donations. These funds may also include designated funds that governing board members use for different projects or specified purposes.

Restricted funds

Restricted funds are those that have specific purposes. These funds include money given by donors who specify purposes and donations an organisation collects during fundraisers. These funds are also referred to as restricted income funds or endowment funds. Members of an organisation's governing body may utilise restricted income funds to fulfil requests of donors or to accomplish the NPO's objectives. Endowment funds are donations that donors give to an NPO, which the organisation invests to derive income from capital.

Temporarily restricted funds

With temporarily restricted funds, an NPO cannot utilise the funds since they have donor-imposed restrictions. The NPO may only use these funds once there are no restrictions, which may happen at a particular time in the future. For instance, if restrictions expire after 15 years, until then, an NPO may work with endowment funds. Although donors may allow the NPO to earn interest on the funds. Temporarily unrestricted funds are also the money that NPOs include in their year-end financial statement.

Related: What Is A Non-profit Organisation? Definition And Key Features

How Does Fund Accounting Work?

For fund accounting to work properly, NPOs are required to prepare fund accounting statements. With the help of these statements, they present information about their resources. This information includes purposes, donor-defined specifications and decisions the board makes to utilise the funds. The efficient working of fund accounting focuses on helping trustees to remain accountable while using the institution's finances, adhering to the NPO's guidelines. While a profit business has capital expenditures, revenues and debts, a non-profit organisation collects funds through donations, gifts and grants.

The management documents receipts of expenses and fund utilisation to present details of how the NPO is using funds. Just like a profit business, an NPO may also register excess and deficits and have assets and liabilities. For example, a fund balance sheet of an educational institution has ₹20 lakh in cash, which becomes the scholarship balance. The institution awards a scholarship of ₹5 lakh to two students and records it as tuition revenue, transferring it to an unrestricted current fund. This transaction marks the cash and restricted fund balance at ₹15 lakh.

Related: What Is A Financial Statement? (With Importance And Types)

Types Of Organisations That Use Fund Accounting

Below are some types of organisations that use fund accounting:

Non-profit organisations

Organisations that do not work for profit are non-profit organisations, like charitable trusts, public clinics, community schools, medical facilities and political organisations. These institutions depend on donations from their supporters. They may also receive grants or funds directly from the state or central government. There are several companies that may also provide sponsorships to fund an NPO. Restricted funding is crucial for NPOs to regulate their expenses.

Governing bodies

Political or governing bodies do not generate profits and depend on the support of their followers or voters. They are required to judiciously spend public money on developmental policies and not use funds for their political campaigns. With the help of fund accounting, a government or a political organisation is better able to monitor its financial standing, as it may be required to share the details of expenditures with taxpayers. For example, during a pandemic, a government creates a relief fund. After the fund receives donations from the people, they enquire about their money and its outcomes.

Religious groups

A religious group has followers who support the group and practise their faith with other members of the group. These followers may give donations to the group for various purposes, like prayer meetings or festivals. When such groups receive funds, they use the money to efficiently carry out routine tasks, work towards their mission and manage expenses associated with the building, like electricity and water bills. For instance, these groups may sponsor a follower's medical treatment for which they organise a fundraiser. These organisations may utilise fund accounting to accurately report why and how they use the money.

Related: What Is The Difference Between Private And Public Sector?

Importance Of Fund Accounting

Fund accounting helps donors and income tax agencies to know how NPOs are utilising donation money. It is important because it makes board members accountable for their decisions. It may satisfy a donor if an NPO uses their money to open a shelter home for the homeless. Although, it may not be pleasing if the NPO uses the donation to buy an expensive painting for its office. Fund accounting is important for donors and revenue agencies to better understand how NPOs use their funds. This accounting system also helps NPOs to remain accountable in different ways:

Accurate allocation

If an NPO is required to allot different amounts for varied projects, they may ensure that they properly allocate all the money. For instance, if there are three projects where each requires ₹20,000, then the NPO makes sure that all the projects receive the exact amount. Proper allocation is efficient when NPOs focus on accountability and not profitability.

Income tax reports

NPOs may be required to report their finances to income tax departments or other revenue agencies. A government may also exempt organisations with charitable purposes from payment of tax. This happens because there are certain NPOs that help the government with implementation of welfare schemes or development delivery systems.

Adhering to restrictions

People may donate money to an NPO and specify purposes, which means that these people tell NPOs for what and when to utilise their donation amount. When they attach these restrictions to their donation, they expect the NPO to abide by them. NPOs that adhere to these restrictions foster trust among their donors.

Continuing operations

Fund accounting helps NPOs to assess their finances and know how much money they have for different operations. With the help of this accounting system, they are better able to prioritise their expenditure and develop efficient budgets that may enable them to accomplish their tasks within the existing finances.

Related: How To Read A Balance Sheet (Components And Template)

Key Principles Of Fund Accounting

Below are the chief principles of fund accounting:

Accountability over profitability

Fund accounting emphasises accountability where NPOs do not work towards earning profits. In fund accounting for NPOs, accountants use excess and deficit instead of profit and loss. An NPO may receive donations from around the world. For efficient management of these global funds, NPOs use fund accounting to identify incoming and outgoing money.

Fund classification

There are varied funds that an NPO may categorise in fund accounting. This accounting in governance includes the responsibilities of trustees, dispensable resources and existing liabilities. In NPO fund accounting, there are different types of funds, like restricted net assets, unrestricted net assets and permanently and temporarily restricted net assets. These funds help NPOs to determine how to manage the money and when to distribute it.

Reports

Unlike a profit business report that involves a balance sheet, NPO reports have a statement of activities and operational expenses. This statement shows net assets, along with expenses associated with administration, programmes and fundraisers. There may be other functional expenses, like a building's rent and insurance. NPOs may prepare accounting reports for revenue agencies, but governments generally exclude them from tax brackets.

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