What Is Fund Accounting and How Does It Work?

Fund accounting is a bookkeeping system used by governments and nonprofits to track whether money was spent the way it was supposed to be spent. Instead of pooling everything into one set of books the way a business does, an organization using fund accounting splits its finances into separate, self-balancing pools called funds, each with its own revenues, expenditures, assets, and liabilities. The purpose is not to measure profit. It is to prove compliance with the restrictions attached to the money — a grant earmarked for road repairs, a donation restricted to scholarships, a tax levy dedicated to debt service.

What a Fund Actually Is

A fund is an independent accounting unit with its own self-balancing set of accounts recording assets, liabilities, equity, revenues, and expenditures for a specific activity. Think of it as a small, standalone set of books inside the larger organization. Money moves into a fund from a defined source, money moves out for a defined purpose, and the fund closes each period with its own balance sheet.

Because most of the money coming into a government or a charity carries strings, this segregation is the whole point. A city cannot legally spend gas tax revenue on library books, and a food bank cannot spend a donor’s scholarship gift on rent. Fund accounting builds that constraint directly into the ledger.

How Fund Accounting Differs From Business Accounting

In commercial accounting, the entire company is one reporting unit. Revenue minus expenses equals net income, and the bottom line tells owners and investors whether the business made money. Fund accounting rejects that model because profit is irrelevant to a city government or a charitable hospital. What matters instead is whether restricted dollars went where they were legally required to go.

The difference shows up on the financial statements. A business reports owner’s equity, the residual claim of shareholders after liabilities are subtracted from assets. A government reports fund balance, the difference between current assets and current liabilities within each fund. A nonprofit reports net assets, split by whether donors placed restrictions on the money.¹

Big-ticket purchases are treated differently too. When a business buys a building, it records the building as a long-term asset and depreciates it over time. When a governmental fund buys a building, it records the entire cost as a current-period expenditure. The money left the fund, and that is what the fund-level statements care about. The building itself and any related long-term debt get reported separately on the government-wide statements, which take a longer view of the entity’s overall financial position.²

That dual perspective — a short-term “did we stay within budget” view at the fund level and a long-term “what is our overall financial position” view at the government-wide level — is the architecture that makes fund accounting distinctive.

How Governments Organize Their Funds

Governments group their funds into three broad categories. Each category serves a different purpose and follows different accounting rules.

Governmental Funds

Governmental funds handle most of a government’s core operations — police, fire, parks, public works — and focus on short-term financial resources. They answer the question: how much money came in, how much went out, and what is left? There are five types:

The General Fund is the catch-all for day-to-day operating transactions that do not belong in another fund. Every government has one.
Special Revenue Funds track money legally restricted to a specific purpose, such as a gas tax that can only be spent on road maintenance.
Capital Projects Funds account for resources dedicated to buying or building major assets like bridges, schools, or water treatment plants.
Debt Service Funds accumulate money set aside for paying principal and interest on long-term government debt.
Permanent Funds hold resources where the principal must stay intact and only the earnings can be spent, benefiting the public. The government cannot unilaterally change a Permanent Fund’s purpose; it must follow the terms under which the resources were received.³

Proprietary Funds

Proprietary funds operate more like businesses. They use full accrual accounting and track long-term assets and liabilities directly because their operations are financed primarily through user fees rather than taxes. There are two types.² Enterprise Funds are used when the government provides services to the public for a fee, such as water utilities, airports, public transit, and parking garages. Internal Service Funds are used when one government department provides services to other departments on a cost-reimbursement basis, such as a centralized motor pool or IT operation.

Fiduciary Funds

Fiduciary funds hold money the government manages on behalf of others, not for its own programs. Because the government is acting as trustee or custodian, these resources cannot be used for government operations. There are four types:⁴ pension and other employee benefit trust funds; investment trust funds for pooled investment arrangements managed on behalf of other governments or entities; private-purpose trust funds where a trust benefits specific individuals or organizations rather than the public; and custodial funds for fiduciary activities not held in a trust, such as taxes collected on behalf of another jurisdiction.

How Nonprofits Do It Differently

Nonprofits use a simpler structure. Under current FASB standards, a nonprofit’s net assets are classified as either “without donor restrictions” or “with donor restrictions.”⁵ Net assets without donor restrictions can be spent on anything the board approves. Net assets with donor restrictions carry conditions imposed by the donor, either temporary (spend only on a named program) or permanent (never spend the principal, only the investment income). When the conditions are met, the money is released from restrictions and reclassified.

Nonprofits also report expenses by both function (program services, management, fundraising) and nature (salaries, rent, supplies). The functional breakdown matters because it lets donors and watchdogs see how much of every dollar goes to the mission versus overhead and fundraising.⁵

Fund Balance: How Much Is Actually Available to Spend

Knowing a fund’s total balance is helpful. Knowing how much of that balance is actually available for new spending is more useful. Governmental fund balances are broken into five categories, ranging from completely locked down to fully flexible:³

Nonspendable — money that cannot be spent because of its form, such as inventories, prepaid items, or the principal of a Permanent Fund.
Restricted — money that can only be spent for purposes imposed by outside parties like grantors, creditors, laws, or constitutional provisions.
Committed — money the government’s highest decision-making authority (usually the governing board or council) has formally earmarked. Undoing this commitment requires equally formal action.
Assigned — money intended for a specific purpose but without the formal commitment. In funds other than the General Fund, any remaining balance not restricted or committed defaults here.
Unassigned — the residual balance in the General Fund with no restrictions, commitments, or assignments. In other funds this category appears only when spending has created a deficit.

A city might show a healthy-looking fund balance, but if most of it is restricted or committed, there is little room to respond to unexpected costs.

Modified Accrual vs. Full Accrual

Fund accounting does not use a single accounting method. Different fund types use different bases of accounting, and the choice reflects what each fund is designed to measure.

Governmental funds use modified accrual accounting. Revenue is recognized when it is both measurable and available to pay current obligations, not simply when earned. Property taxes billed but not expected to be collected within a reasonable period after year-end are deferred rather than recorded as revenue. Expenditures are recognized when the related liability is incurred, with one notable exception: principal and interest on long-term debt are recognized only when they come due, not when the debt is first issued.² When a government issues bonds, the proceeds are not recorded as revenue — they are borrowed money, not earned income — but as an “other financing source” in the governmental fund.

Proprietary and fiduciary funds use full accrual accounting, the same method commercial businesses use. Revenue is recognized when earned and expenses when incurred, regardless of when cash changes hands. This fits enterprise funds running utility systems or transit operations, where long-term performance matters as much as current-year cash flow.⁶ The government-wide statements also use full accrual, which is where the two perspectives merge: fund-level statements show whether each fund stayed within its legal spending limits, and government-wide statements show the organization’s total economic position.²

Encumbrances and Budgetary Control

One practical mechanic that sets fund accounting apart is encumbrance accounting, a system for reserving budget authority the moment a commitment is made rather than when the bill arrives. If a city’s parks department signs a $50,000 contract for playground equipment in March, the accounting system immediately encumbers that $50,000 against the parks budget. The money has not been spent, but it is no longer available for anything else.⁷

This is where fund accounting earns its reputation as a control system. Encumbrances prevent departments from accidentally overspending by making committed dollars visible before the invoice shows up. When the equipment is delivered and the invoice arrives, the encumbrance is reversed and replaced with an actual expenditure. Outstanding encumbrances at year-end are not expenditures or liabilities; they represent contracts still in progress, and significant encumbrances must be disclosed in the notes to the financial statements. If a purchase order is still outstanding when the fiscal year closes, the government reserves that amount in fund balance so the money carries forward into the next year.⁷

Who Sets the Rules

Two separate bodies set fund accounting standards in the United States, and which one applies depends on whether the organization is a government or a nonprofit.

The Governmental Accounting Standards Board (GASB) sets the rules for state and local government entities, including cities, counties, school districts, public universities, and special-purpose authorities like water districts and public transit agencies.⁸ GASB Statement No. 34 established the dual-perspective reporting model that requires both fund-level and government-wide financial statements.² GASB Statement No. 103, effective for fiscal years beginning after June 15, 2025, updates several components of that model, including tighter requirements for Management’s Discussion and Analysis and new rules for presenting unusual or infrequent items.⁹

The Financial Accounting Standards Board (FASB) governs accounting for nonprofits that are not governmental — charities, private universities, trade associations, religious organizations, and similar entities. Under FASB’s framework (primarily ASC Topic 958), nonprofits do not use the governmental fund structure. They classify their net assets by donor restrictions and report expenses by function and nature.⁵

What Gets Reported

Government entities produce two parallel sets of financial statements — fund-level and government-wide — plus reconciliations bridging the two. This dual reporting is a core requirement of GASB Statement No. 34.²

The government-wide statements treat the entire government as a single economic entity using full accrual accounting. The Statement of Net Position functions like a commercial balance sheet, reporting all assets, deferred outflows, liabilities, and deferred inflows, with the difference classified into net investment in capital assets, restricted net position, and unrestricted net position. The Statement of Activities works differently from a commercial income statement: it presents each government function’s expenses reduced by its own program revenues to arrive at a net cost for each function. General revenues like property taxes are then reported separately, so the format shows exactly how much each function depends on general tax revenue.

At the fund level, governmental funds report on a Statement of Revenues, Expenditures, and Changes in Fund Balances using modified accrual accounting. Because the two sets of statements use different accounting bases, a reconciliation accompanies the fund statements to explain the differences, primarily the inclusion of long-term assets and debt on the government-wide statements. Proprietary funds produce a statement of net position, a statement of revenues, expenses, and changes in fund net position, and a statement of cash flows using the direct method. Fiduciary fund statements report the resources held for outside parties.

All of this gets packaged into an Annual Comprehensive Financial Report, or ACFR, covering all funds and activities of the primary government and its component units. The ACFR has three sections: an introductory section with a letter of transmittal and organizational information; a financial section containing MD&A, basic financial statements, notes, required supplementary information, and combining statements for nonmajor funds; and a statistical section with multi-year trend data.¹⁰

Audits and What Happens When Restricted Funds Are Misused

Organizations that receive federal funding face an extra audit layer. Under the federal Uniform Guidance, any non-federal entity — government or nonprofit — that spends $1,000,000 or more in federal awards during a fiscal year must undergo a Single Audit. Entities below that threshold are exempt from federal audit requirements, though their records must remain available for review by federal agencies and the Government Accountability Office.¹¹ A Single Audit is more intensive than a standard financial audit. It examines not just whether the financial statements are fairly presented but whether the entity complied with the specific requirements of each federal program it administered.

State-level audit thresholds for nonprofits vary widely, from around $500,000 in gross revenue to $2,000,000 or no fixed statutory threshold. The underlying question is always the same: did the organization spend restricted money only on its intended purpose?

When that system fails, the consequences come from multiple directions. State attorneys general have broad authority to investigate and act against nonprofits that misapply, divert, or waste charitable assets, with tools that include lawsuits to recover misused funds and removal of directors who breached their fiduciary duties. Directors face personal exposure for self-dealing, fraud, waste, and abuse of discretion. Donors can also sue; courts increasingly recognize standing for donors and other parties with a significant interest in the funds, even though the attorney general has traditionally held primary enforcement authority. A nonprofit that fails to use restricted funds as required also risks losing its tax-exempt status, which is often an existential threat.

For governments, mismanaging restricted funds — spending bond proceeds on unauthorized purposes, diverting grant money — can trigger federal clawback demands, loss of future grant eligibility, and political fallout. Fund accounting exists specifically to prevent these outcomes. Organizations that treat it as a live compliance discipline rather than a paperwork formality are the ones that stay out of trouble.

1
National Center for Education Statistics. Financial Accounting for Local and State School Systems – Financial Reporting Fund Balance and Net Assets
2
GASB. Summary – Statement No. 34
3
GASB. Summary – Statement No. 54
4
GASB. Summary – Statement No. 84
5
Financial Accounting Standards Board. Statement of Financial Accounting Standards No. 117
6
National Center for Education Statistics. Financial Accounting for Local and State School Systems 2009 Edition – Expenditures
7
Governmental Accounting Research System. 1700 – The Budget and Budgetary Accounting
8
GASB. Statement No. 2 – Financial Reporting of Deferred Compensation Plans
9
GASB. Summary – Statement No. 103
10
Governmental Accounting Research System. 2200 – Annual Comprehensive Financial Report
11
eCFR. 2 CFR 200.501 – Audit Requirements