Fund accounting is the system nonprofits and governments use to track money by the purpose it was given for rather than by the profit it produces. Every dollar sits inside a fund tied to a donor restriction, a grant condition, or a legal appropriation, and the books are built to prove that dollar stayed where it was supposed to. Two separate standard-setters govern the field: the Financial Accounting Standards Board (FASB) writes the rules for non-governmental nonprofits, and the Governmental Accounting Standards Board (GASB) writes the rules for state and local governments.1Financial Accounting Standards Board. Not-for-Profits The mechanics differ between the two, but the underlying idea is the same.
Why the System Exists
Commercial accounting is built around a single question: did the business make money? Assets equal liabilities plus equity, and everything rolls up to net income. Fund accounting reorders the priorities. The equation becomes assets equal liabilities plus net assets (nonprofits) or fund balance (governments), and the reporting exists to show that restricted resources were kept restricted.
A for-profit company can move cash freely to wherever it earns the best return. A nonprofit that receives a grant earmarked for literacy programs cannot redirect that money to cover a shortfall in its food bank, even though both further the mission. Fund accounting enforces that wall by keeping each pool of money in its own self-balancing set of accounts. It is the reason a charity can hold millions in assets and still struggle to pay the electric bill: most of the money is locked to a purpose.
How Nonprofits Classify Net Assets
FASB’s current standard, ASU 2016-14, requires nonprofits to sort every dollar of net assets into one of two categories, down from three under the older FAS 117.2Financial Accounting Standards Board. Accounting Standards Update No. 2016-14
Net assets without donor restrictions are resources carrying no external strings. This covers general operating funds, fee-for-service revenue, and any amounts the board has designated internally for a specific purpose. A board designation is not a donor restriction. The board can reverse its own decision at any time.
Net assets with donor restrictions are resources a donor or grantor has earmarked for a specific purpose, a specific time period, or both. This single category captures everything the older system split between “temporarily restricted” and “permanently restricted.” Permanent endowments, where the principal must stay intact indefinitely and only the earnings can be spent, live here alongside time-limited grants and purpose-restricted gifts.2Financial Accounting Standards Board. Accounting Standards Update No. 2016-14
The financial statements report each class separately, so a reader can see at a glance how much of the organization’s wealth is actually available for discretionary use.
How Governments Classify Fund Balance
GASB Statement No. 54 uses a more granular five-tier system called fund balance, ordered by how strong the constraint on spending is.3Governmental Accounting Standards Board. Summary – Statement No. 54
Nonspendable covers resources that cannot be spent because of their form, such as inventory or prepaid items, or because they must be maintained intact, like the principal of a permanent fund.
Restricted covers amounts that can be spent only for purposes imposed by outside parties (creditors, grantors, other governments) or through constitutional provisions and enabling legislation.3Governmental Accounting Standards Board. Summary – Statement No. 54
Committed covers amounts locked in by formal action of the government’s highest decision-making authority, usually the full legislative body. Undoing a commitment takes the same level of formal action that created it.
Assigned covers resources intended for a specific purpose but without a formal commitment. In funds other than the general fund, assigned is the default classification for anything that isn’t restricted or committed.3Governmental Accounting Standards Board. Summary – Statement No. 54
Unassigned is the residual for the general fund. This is the money truly available for anything. In other governmental funds, an unassigned amount appears only when spending has exceeded restricted, committed, and assigned amounts, producing a deficit.
When reviewing a government’s financial condition, the unassigned fund balance in the general fund is the number to watch. It shows the real breathing room.
When Revenue and Spending Get Recorded
Fund accounting uses two different timing rules for recognizing revenue and spending, depending on the entity and the type of fund.
Full Accrual
Nonprofits use full accrual across the board. Governmental proprietary funds (such as water utilities) and fiduciary funds (such as pension trusts) also use it. Revenue is recorded when earned and expenses when incurred, regardless of when cash actually moves. A nonprofit that sends an invoice in December records the revenue in December, even if payment does not arrive until February.
Modified Accrual
Governmental funds (the general fund, special revenue funds, capital project funds, debt service funds, and permanent funds) use modified accrual. The focus shifts from long-term economic activity to current financial resources: cash and near-cash available to pay current obligations.
Revenue is recognized only when both measurable and available. “Available” generally means the government expects to collect the money soon enough after the fiscal year ends to pay liabilities from that year. Property tax recorded in June, for example, must be collectible within a short window after fiscal year-end to count as that year’s revenue.
Spending under modified accrual is recorded as “expenditures” rather than “expenses,” and the distinction matters. When a government buys a building, the full purchase price hits the books as a current-year expenditure. There is no capitalization and no depreciation schedule the way a business or a proprietary fund would handle the same purchase.
Encumbrance Accounting
Governments face a constraint most nonprofits do not: legally adopted budgets that cap spending by category. Encumbrance accounting exists to keep departments from busting those appropriations. When a government issues a purchase order, the committed amount is immediately recorded as an encumbrance, reserving that portion of the budget even though no payment has been made and no goods have arrived.
Consider a department with a $500,000 supply budget that issues a $50,000 purchase order. The encumbrance system instantly reduces the available balance to $450,000. Without that step, a manager checking the budget could see $500,000 still sitting there and unknowingly authorize spending past the legal limit. When the vendor delivers and the invoice is paid, the encumbrance reverses and an actual expenditure entry takes its place. Encumbrances still open at fiscal year-end typically carry forward to the next year as reserved amounts.
Booking and Releasing Restricted Contributions
Contributions are non-exchange transactions: the donor gets no direct economic benefit in return. FASB requires nonprofits to recognize contributions at fair value when received, or when an unconditional promise to give is made.4Financial Accounting Standards Board. Not-for-Profit Entities (Topic 958)
An unconditional pledge (“I will give your organization $100,000 next year”) is recorded immediately as revenue and a receivable, even though no cash has arrived. A conditional promise stays off the revenue line until the condition is met. For a promise to be conditional, it has to include both a barrier the nonprofit must overcome and a right of return or release if the barrier isn’t met.4Financial Accounting Standards Board. Not-for-Profit Entities (Topic 958) Until then, the funds are recorded as a refundable advance, which is essentially a liability. When donor stipulations are ambiguous, the default is to treat the contribution as conditional. An organization that aggressively books conditional grants as revenue overstates its position and risks spending money it may have to return.
Revenue received with a donor restriction goes into net assets with donor restrictions and stays there until the restriction is satisfied, either by spending the money on the designated purpose or by the passage of the required time. When that happens, the organization records a reclassification, moving the amount from restricted to unrestricted net assets. If a donor gives $50,000 for new computers, the restriction releases when the computers are purchased. A time restriction lifts when the specified date arrives. This recognize-then-release sequence is the core mechanism that makes fund accounting work for restricted gifts.
The Financial Statements
FASB requires nonprofits to produce three primary statements.2Financial Accounting Standards Board. Accounting Standards Update No. 2016-14 The Statement of Financial Position is the nonprofit balance sheet. It reports total assets, total liabilities, and the two classes of net assets. The Statement of Activities replaces the income statement, but instead of a single bottom-line profit, it shows the change in each class of net assets during the period, including how much was released from restrictions. The Statement of Cash Flows tracks actual cash by operating, investing, and financing activity. That last one matters because accrual statements can mask cash problems. Strong revenue growth on the Statement of Activities can sit alongside a serious cash squeeze.
ASU 2016-14 also added a liquidity disclosure. Nonprofits must provide qualitative and quantitative information about the financial resources available to cover operating needs over the next year, after accounting for donor restrictions and internal designations.2Financial Accounting Standards Board. Accounting Standards Update No. 2016-14 The disclosure answers a long-standing complaint that nonprofit balance sheets made it hard to tell whether the organization could actually pay its bills.
Every nonprofit must also present an analysis of expenses by both function (program services versus supporting activities such as management, general, and fundraising) and nature (salaries, rent, supplies, depreciation).2Financial Accounting Standards Board. Accounting Standards Update No. 2016-14 The ratio of program spending to total spending is one of the most watched metrics in the sector.
Form 990 Filing Obligations
Tax-exempt organizations file an annual information return with the IRS, and the form depends on size.5Internal Revenue Service. Form 990 Series Which Forms Do Exempt Organizations File Organizations with gross receipts normally $50,000 or less file Form 990-N (the e-Postcard). Organizations with gross receipts under $200,000 and total assets under $500,000 file Form 990-EZ, though filing the full Form 990 is always an option. Once gross receipts reach $200,000 or total assets reach $500,000, the full Form 990 is required.
Missing the filing is expensive. Late returns trigger a $20 per day penalty, up to the lesser of $10,500 or 5 percent of gross receipts for the year. Larger organizations with gross receipts above roughly $1 million face steeper per-day penalties.6Internal Revenue Service. Annual Exempt Organization Return – Penalties for Failure to File Fail to file for three consecutive years and the organization automatically loses its tax-exempt status. There is no warning, no appeal, and no discretion; revocation takes effect on the due date of the third missed return.7Internal Revenue Service. Automatic Revocation of Exemption Reinstatement requires a new application and fees, and donations during the gap are not tax-deductible.
Unrelated Business Taxable Income
Being tax-exempt does not make every dollar of income tax-free. When an exempt organization regularly conducts a trade or business that is not substantially related to its exempt purpose, the net income is unrelated business taxable income (UBTI). The tax code defines UBTI as gross income from an unrelated trade or business, minus directly connected deductions, with a specific deduction of $1,000.8Office of the Law Revision Counsel. 26 USC 512 – Unrelated Business Taxable Income
If gross income from unrelated business activities reaches $1,000 or more, the organization must file Form 990-T and pay tax at the applicable corporate rate on the net income.9Internal Revenue Service. Instructions for Form 990-T Common examples include advertising revenue in a nonprofit magazine, rental income from debt-financed property, and commercial services sold to non-members. Ignoring UBTI risks penalties and, in extreme cases, exempt status itself. Fund accounting helps by keeping unrelated business activity in its own accounts, so taxable income can be calculated without contaminating exempt-purpose reporting.
The Single Audit Threshold
Any non-federal entity, nonprofit or government, that spends $1,000,000 or more in federal awards during its fiscal year must undergo a single audit under the Uniform Guidance.10eCFR. 2 CFR 200.501 – Audit Requirements The single audit goes beyond a normal financial statement audit and tests whether federal money was spent in compliance with the specific requirements of each program.
Organizations that spend less than $1,000,000 in federal awards are exempt from the single audit, though records must remain accessible to federal agencies and the Government Accountability Office.10eCFR. 2 CFR 200.501 – Audit Requirements Findings of noncompliance can trigger repayment demands, funding suspensions, or disqualification from future awards. The audit itself can run tens of thousands of dollars depending on how many federal programs are involved, so organizations approaching the threshold should weigh that cost when deciding whether to take on additional federal grants. Keeping each grant in its own segregated fund is what makes the audit workable in the first place.