Nonprofits and government agencies need fund accounting to demonstrate accountability and compliance. By classifying funds, a fund accounting system tracks revenue to a designated purpose and prevents misuse of donations.
If a nonprofit wants to be compliant with GAAP and FASB 116/117, all of their funds must be grouped into two categories of net assets: (1) without donor restrictions and (2) net assets with donor restrictions, which replace the three former categories of unrestricted, temporarily restricted and permanently restricted net assets. To be GAAP-compliant, nonprofits only need two funds to report on the breakdown of net assets on IRS form 990.
Fund Accounting Identifies Who, What and Why
In order to fully understand why nonprofits need fund accounting, you need to understand three fundamental questions:
- Who is the source of revenue?
- What is the designated purpose?
- Why nonprofits need to classify revenue?
1. Who is the source of revenue?
Who identifies the source of revenue and provider of services and expenses. This is know as donor designated revenue. Who is donating or granting funds to the nonprofit? Who is the nonprofit paying expenses, such as salaries, payroll taxes, services, rent, utilities?
2. What is the designated purpose of the revenue?
Fund accounting helps a nonprofit identify ‘what’ their revenue is designated for, and to monitor the restrictions often attached to the revenue. This provides stewardship and transparency. By identifying revenue into appropriate designations, nonprofit accounting enables organizations to keep the revenue it receives in the proper classifications and prevents this revenue from being spent on inappropriate expenses. It also highlights areas of strength and weakness, providing transparency for funding sources.
It allows nonprofit to manage the diverse streams of revenue they receive and monitor the donor restrictions often attached to revenue. By breaking up an entity’s finances into appropriate funds, fund accounting enables organizations to keep revenue it receives in the proper categories and prevent revenue from being spent on inappropriate expenses. Each fund will have its own revenue and expense report, its own excess or deficiency calculation and its own balance sheet.
3. Why do nonprofits need to classify revenue using fund accounting?
To properly track revenue and expenses separately, you will need to setup a fund accounting system and a specific code for these transactions. This type of system provides organizations with a method to measure how they are meeting their goals.
Each nonprofit has its own set of programs, administrative and fundraising activities known as functional accounting. Separate funds are established for these entities to track how revenue and expenses are spent.
This answers why this type of revenue was received and the type of expense incurred. It classifies the type of revenue and expense of each transaction. It is standard for all accounting and it is a detailed list of the nature of each revenue — grants, program services, contributions and fundraising events — and expenses, such as salaries, payroll taxes, rent, professional services, etc.
All revenue coming into your organization and expenses going out need to be identified with an account code corresponding to the funding source, or expense (who), the revenue or expense’s functional area (what) and the type of revenue and expense (why) of the transaction.
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