Fund accounting: best practicesNonprofit funding from sources such as grants, major gifts and endowments often comes with certain restrictions. In some cases, these restrictions are time-based — with the funds held for months or years before they can be used or, conversely, funds that must be used before a certain date. In other cases, the funds may be directed for particular purposes, such as the purchase of specific goods, supplies or services.
Nonprofits that receive restricted funds typically practice fund accounting, which requires that funds from different sources and funds dedicated to specific purposes be accounted for separately.
While restricted funds might seem like a headache, especially for smaller nonprofits, allowing donors some input in the use of their financial gifts is one way to incentivize major gift-giving. Donors who have a say in how their funds are used may better feel — and see — the direct benefits of their gifts.
What types of restrictions are allowed?
Restrictions are requirements that a donor or grantor imposes on the use of funds. By law, the donor — and only the donor — can impose restrictions on a nonprofit's use of funds. In turn, the nonprofit is legally required to abide by those restrictions.
Funds donated for specific campaigns or purposes are considered restricted by default, whether it's a capital campaign or for a winter coat drive. If a donor gives even a few dollars for a specific purpose, you've entered into what's essentially a legally binding contract that requires those funds to be used for the intended purpose.
Endowment funds, which are often a subset of restricted funds, are gifts intended as investments. The principal remains restricted, but the nonprofit can use the interest and any returns earned by the investment. Sometimes the earnings themselves may be restricted — for example, to support scholarship funds or particular programs or initiatives.
What are some accounting best practices for restricted funds?
While it's not necessary to keep different bank accounts, restricted and unrestricted funds must be kept separate. This is the purpose of fund accounting, and why nonprofits often have a grid-style statement of financial position rather than a single-column balance sheet.
Each fund is, in some ways, its own business, with its own assets and liabilities. As such, each fund should have its own ledger. If you have multiple restricted funds, you'll need multiple accounts and multiple ledgers. As complicated as this may seem, accounting software created for nonprofits is typically designed to handle these separate funds — making bookkeeping practices clear, straightforward and manageable.
Consider these key points about restricted funds:
- Pay attention to timing. Funds must be recorded on the balance sheet when they're promised, such as when you receive an award letter or other pledge of funding — rather than when you receive the money itself. This is accrual accounting.
- Restricted funds must be kept separate from other funds. Separate restricted and unrestricted funds during the budgeting process. Similarly, monitor the use of returns and interest from invested funds.
- Know when the restrictions are met. When time or purpose restrictions are met (as in the case of temporarily restricted funds), you may be able to transfer remaining funds to the unrestricted ledger. In other cases, unused funds must be returned to the donor or grantor.
- Internal controls count. Internal controls should include clear monitoring of asset restrictions as well as the movement of funds as restrictions change or expire.
- Track outcomes. Since restrictions are often purpose-based, it's important to monitor how well that purpose is accomplished. This is important not only for accounting purposes, but can be an important fundraising tool that helps you communicate the impact of a particular gift to the original donors as well as recruit potential new supporters.