What Is Fund Accounting and How Does It Work?

Fund accounting is a specialized financial management method primarily used by organizations that do not focus on generating profits. This system tracks the allocation and use of financial resources, emphasizing stewardship and accountability. Its fundamental purpose is to demonstrate how funds entrusted to an organization have been utilized in accordance with specific mandates or donor intentions. Fund accounting provides transparency, ensuring that financial activities are clearly reported to stakeholders.

The Concept of a Fund

In fund accounting, a “fund” represents a distinct fiscal and accounting entity, comprising a self-balancing set of accounts. This structure is designed to segregate resources that have specific purposes or restrictions on their use. Each fund operates independently, allowing for precise tracking of inflows and outflows related to a particular activity or objective. This separation ensures that financial resources are managed and reported according to their designated use.

Funds are broadly categorized as either restricted or unrestricted. Unrestricted funds are those that the organization can use at its discretion for any legal purpose that supports its mission, offering flexibility for general operations or unforeseen needs. Conversely, restricted funds come with specific limitations imposed by donors, grantors, or legal mandates, meaning they must be used for a particular program, project, or within a specified time frame. This distinction is fundamental to maintaining accountability and compliance with external requirements.

Unique Characteristics of Fund Accounting

Fund accounting differs significantly from commercial accounting, which primarily focuses on profitability. A core principle of fund accounting is demonstrating stewardship and accountability for resources. The aim is to show how funds received have been used effectively and in alignment with the intentions of donors or legal requirements, rather than measuring a profit or loss. This emphasis ensures that organizations responsibly manage the contributions they receive.

A defining characteristic is the strong emphasis on restrictions. External parties, such as donors or grantors, often impose conditions on how their contributions can be utilized. Fund accounting systems are specifically designed to track compliance with these restrictions, ensuring that funds are spent only for their designated purposes. This detailed tracking builds trust with stakeholders by providing clear evidence of adherence to their stipulations.

Instead of “owner’s equity” or “retained earnings” found in commercial accounting, fund accounting uses “net assets.” Under current Financial Accounting Standards Board (FASB) guidance, specifically Accounting Standards Update 2016-14 (part of FASB Accounting Standards Codification 958), net assets are now presented in two main categories: “without donor restrictions” and “with donor restrictions.” Net assets without donor restrictions include funds that can be used at the discretion of the organization, as well as internally designated funds by the board. Net assets with donor restrictions are subject to donor-imposed limitations, which can be perpetual in nature (like endowments where the principal must be maintained indefinitely) or temporary (for a specific purpose or time).

The absence of a profit motive further distinguishes fund accounting. Organizations employing this method do not aim to generate a profit in the traditional sense. Instead, their financial reporting focuses on changes in net assets over time, reflecting how effectively resources are managed and deployed to achieve the organization’s mission. This approach aligns financial reporting with the non-profit or governmental objectives of service and public benefit.

Organizations Employing Fund Accounting

Fund accounting is primarily utilized by entities that operate without a profit motive and are entrusted with resources for specific purposes. Non-profit organizations are a major category that employs this accounting method. This includes a wide array of entities such as charities, foundations, hospitals, universities, and religious institutions. For these organizations, fund accounting is necessary to manage diverse funding sources, which often come with specific mandates from donors or grantors.

Governmental entities also rely heavily on fund accounting. This encompasses federal, state, and local governments, including agencies and public school systems. For governments, fund accounting is essential for demonstrating public accountability and ensuring compliance with legal and regulatory requirements concerning public funds.

Both non-profits and governmental bodies utilize fund accounting to segregate financial resources, enabling them to show stakeholders, such as donors, taxpayers, and oversight bodies, that funds are being used precisely as intended. This practice is crucial for maintaining trust and fulfilling their missions.

Financial Reporting in Fund Accounting

Financial reporting in fund accounting provides a comprehensive view of an organization’s financial health and its adherence to resource restrictions. The Statement of Financial Position, similar to a commercial balance sheet, presents the organization’s assets, liabilities, and net assets at a specific point in time. It classifies net assets as either “without donor restrictions” or “with donor restrictions,” providing transparency regarding the availability and limitations of resources.

The Statement of Activities serves as the equivalent of an income statement, detailing revenues, expenses, gains, and losses over a period. This statement illustrates how these activities impact the different classes of net assets, showing the changes in both “net assets without donor restrictions” and “net assets with donor restrictions.” It allows stakeholders to understand how the organization’s operations affect its overall financial position.

A Statement of Cash Flows reports the cash inflows and outflows, categorized into operating, investing, and financing activities. While similar in structure to commercial cash flow statements, it considers the unique context of non-profit and governmental operations, such as cash received from contributions and grants. This statement helps assess an organization’s liquidity and its ability to meet short-term obligations.

For non-profit organizations, the Statement of Functional Expenses provides a detailed breakdown of how expenses are allocated. This statement typically categorizes expenses by function, such as program services (costs directly related to the mission), management and general (administrative costs), and fundraising expenses. It also often shows expenses by their natural classification, such as salaries, rent, and utilities. This detailed allocation demonstrates how resources are being used to achieve the organization’s mission and provides accountability to donors and regulators.