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When you think about what’s necessary to fundraise successfully at your nonprofit, organized financial records might not be at the top of your list. However, a strong accounting system is essential not only for tracking revenue generation but also for allocating funding so it furthers your mission and so you can maintain compliance with nonprofit regulations.
The most effective way to organize your nonprofit’s finances is fund accounting. Jitasa’s fund accounting guide defines this term as “a method of financial management that tracks the amount of money allocated to various operations at a tax-exempt organization. This system is designed to ensure your nonprofit uses funds productively and respects stakeholders’ wishes regarding their gifts.”
In this guide, we’ll discuss some best practices for incorporating fund accounting into your nonprofit’s financial management processes and making the most of this system. Let’s get started!
Understand the Categories of Funds in Fund Accounting
The primary purpose of a fund accounting system is to help your nonprofit honor any donor- or funder-imposed restrictions on revenue. When supporters give large amounts to your organization, they often want some control over how that money is spent, so they’ll designate it for specific purposes that align with their values or priorities.
This means all of the funding your nonprofit receives falls into one of these three categories:
- Unrestricted funds: These contributions have no designations attached to them, so you can put them toward any area of your organization’s budget—mission-critical programs and projects, administrative activities, or upfront costs of fundraising. Most small to mid-sized individual donations, corporate contributions like matching gifts and volunteer grants, and earned income such as membership dues and merchandise sales fall into this category.
- Permanently restricted funds: These usually take the form of endowments, which Infinite Giving defines as “a dedicated source of long-term funding made up of donations that support a philanthropic organization’s mission and work… Generally, endowments are designed to keep their initial investment amount (the principal) intact and growing, spending only the investment income” on an agreed-upon ongoing initiative.
- Temporarily restricted funds: Major and planned gifts, corporate sponsorships, and government and foundation grants typically fall into this category. These contributions’ designations apply to specific projects or for certain time periods. If any funding remains once the project is completed or the time elapses, your nonprofit can release that funding from restriction with the funder’s permission.
Misallocating your nonprofit’s restricted funds, whether it happens intentionally or accidentally, doesn’t just impact large-dollar supporters’ trust in your organization. Donor-imposed funding designations are legally binding, so you also run the risk of lawsuits or fines if you spend this money incorrectly. But as long as you know which funds belong in which categories and track revenue accordingly, you’ll avoid these issues and be better equipped to fund your most critical initiatives.
Choose Accounting Software Carefully
When your nonprofit was first established, you probably tracked its revenue and expenses in a spreadsheet. While this method is convenient for small and new organizations, proper fund accounting requires you to leverage a dedicated platform.
Your accounting software should either be designed specifically for nonprofits or be easily configurable for nonprofit use. No matter which option you choose, here are a few tips for ensuring your solution supports proper fund accounting:
- Select a high-value subscription plan. You should invest in accounting software when it’s affordable, when spreadsheets are no longer manageable, or when your organization grows to a size that requires it. Compare pricing plans (including additional fees, free trials, and discounts) to ensure you can access all of the features you need for the most reasonable cost.
- Choose the right organization type for the interface. If your platform isn’t nonprofit-specific, it’ll probably have a dropdown list of organization types. Double-check that you’ve selected “nonprofit” so the software uses nonprofit-specific terminology and provides the features you need to meet your organization’s requirements..
- Integrate other software and data sources. Connect your nonprofit’s bank accounts, donor database, payment processor, and other fundraising tools to your accounting software to allow for automatic, seamless data transfer between platforms.
- Enable restricted fund tracking. Especially with generic platforms, you may have to turn this feature on, use specific projects, or create categories manually, but it’ll be worth it in the long run to monitor funding designations.
- Include restrictions on your chart of accounts. You’ll also need to customize this directory of your financial records during setup. Separate your nonprofit’s net assets into restricted and unrestricted categories, and create distinct divisions for commonly restricted income sources in the revenue section.
If you need help or have questions about any of these steps, don’t hesitate to contact a nonprofit accountant or financial advisor who has experience with your platform. They probably will have set up that solution for many other nonprofits and can draw on their experience to configure yours so you can sustainably leverage fund accounting.
Incorporate Fund Accounting Into All Financial Activities
Once you have your tracking set up, your fund accounting system will impact every aspect of your nonprofit’s financial management practices. The areas where you’ll likely see its effects most prominently include:
- Budgeting. As you develop your organization’s annual operating budget, allocate restricted revenue to the proper initiatives first, then fill in any gaps with unrestricted funding.
- Financial statement creation. On your statements of activities and financial position (the nonprofit equivalents of a for-profit income statement and balance sheet, respectively), separate net assets into restricted and unrestricted categories.
- Annual reporting. Along with attaching your financial statements to your annual report as appendices, include general information about restricted funds in the financial charts and graphs within the body of your report to cultivate donor trust.
- Tax filing. The IRS also wants to know how much of your revenue is restricted and how you spent it to ensure your nonprofit still deserves its tax-exempt status. So, you’ll need to include this information on your annual tax return (IRS Form 990).
These wide-reaching applications are why every employee and board member at your nonprofit should have a basic understanding of fund accounting. Although most of your team won’t touch your financial records directly in their everyday work, they still need to understand restricted funds so they can contribute to budget discussions, publish external-facing reports, and pursue the right donations and grants to help your organization achieve its goals.
Fund accounting is essential for every area of your organization’s operations to run smoothly, from fundraising to service delivery to administration. Use these tips to get started, and remember that you can always reach out for professional help with implementing your system and ensuring it supports your mission long-term.
