While there are plenty of similarities between the accounting systems used by commercial businesses and Nonprofit Organizations (NPOs), the key difference lies in their sources of revenue. In commercial business, revenue comes from sales or profits from investments. In NPOs, revenue is a combination of sales or investments plus contributions (which are usually so significant that without them, the organization would not be able to operate).
NPOs must also differentiate between contributions and all other sources of revenue, as contributions can often come with restrictions. In Canada, many NPOs choose to track and report on their finances using fund accounting. Fund accounting is an accounting system that uses the restricted fund method to help distinguish between restricted and unrestricted contributions in their financial reports. Contributions can be restricted or unrestricted and these can be tracked using the deferral method of accounting or the fund method of accounting.
Deferral Method vs. The Fund Method
We have an in-depth article on this topic linked here, but in summary: The deferral method of accounting is simple and less complex to implement and maintain. This is often used by small organizations with unrestricted contributions. The fund method of accounting is more complex and requires higher efforts to prepare and maintain. This method is preferable for larger organizations with multiple restricted contributions.
It is not mandatory for an organization to follow either accounting method to track contributions; however, the use of one over the other can have a significant impact on the organization.
The use of fund accounting is not mandatory but rather a policy choice. Some organizations opt to use the deferral method as an alternative. Small organizations that don’t receive restricted contributions from donors might choose the deferral method due to its simplicity. Fund accounting creates clear divisions revenues, making it a good choice for organizations with diverse funding sources.
What is NPO Fund Accounting?
In fund accounting, an organization will divide its resources into funds, resulting in a self-balancing set of accounts. Each fund is set up similarly to a general ledger and made up of a combination of assets, liabilities, revenues, expenses, and a net asset balance (also known as a fund balance). While commercial businesses will rely on a single general ledger, NPOs who use fund accounting will have multiple funds.
Revenue for NPOs can be derived from a number of sources including donations, fees for service, event ticket sales, grants, membership purchases and renewals, and investments.
Donations, also called contributions, are typically the biggest driver of revenue for NPOs, but this type of financial support can come with stipulations designated by the donor.
Donations can also take the form of pledges, which represent a future monetary commitment, bequests, which are written into a donor’s will, and donations-in-kind of goods and services. These three categories all require special considerations when it comes to financial reporting and will also often come with restrictions.
Setting up NPO Funds Based on Restriction Types
At a high level, contributions can be classified as unrestricted and restricted. Only the donor can determine whether or not a donation is restricted and specify whether that restriction is temporary or permanent.
Unrestricted contributions can be used for any purpose by the organization and are often applied to administrative or operational costs. Temporarily restricted contributions can be limited by time, purpose, or even location.
For time-limited temporary restrictions, the restriction time period must elapse before the money can be spent, after which the contributions become unrestricted and can be used however the organization sees fit. Contributions that are limited by purpose are often collected during campaigns for specific projects, like building renovations or new equipment and material purchases. Once the project is complete, most temporarily restricted contributions will become unrestricted.
Permanently restricted contributions will remain restricted forever and cannot be used directly. Examples of permanently restricted contributions include endowments or scholarship funds. In this case, the principal amount is invested and the organization is only able to spend the interest generated. The principal amount can only be used for specific activities or projects as designated by the fund.
In the simplest form of fund accounting, organizations will have two funds: an unrestricted fund and a restricted fund. Some organizations may drill down further to create separate funds based on the type of restrictions (temporary vs. permanent), and whether the restrictions have been imposed externally by donors or internally for the organization's board.
NPO Financial Statements
NPOs will produce three distinct financial reports through Fund Accounting:
- a Statement of Financial Position
- Statement of Operations and Changes in Fund Balances,
- and a Statement of Cash Flows.
The Statement of Operations and Fund Balances lays out the revenues, expenditures and any excess or deficiencies for each individual fund, as well as the resulting change in fund balances for the reporting period. Similarly, the Statement of Financial Position lists the assets and liabilities that make up the fund balance for each fund. However, the Statement of Cash Flows differs by showing only the cash flow total, across all funds, as an aggregate.
In external reports, organizations will include the purpose of each fund, outline the types of expenses included, and how the fund is used to pay for those expenses based on the fund’s contribution restrictions.
The Future of NPO Fund Accounting
The Accounting Standards Board (AcSB) is engaged in ongoing research into how revenue from contributions should be tracked and reported by NPOs. Specifically, the Board plans to examine current accounting practices among NPOs, including the choice to use the restricted fund method and fund accounting over the deferral method. The research will also drill down into the types of contributions NPOs typically receive and the restrictions that are imposed by donors and other contributors.
For Canadian NPOs that use fund accounting as their preferred accounting system, the results of this research could have a significant impact on future accounting standards.
Fund accounting provides organizations with a clear way to stay accountable to donors by showing that donations are being spent according to their wishes. The increased transparency will serve to strengthen donor relationships over the long term. Moreover, using fund accounting could help organizations attract potential donors that would prefer more detailed reporting.
With a great deal of experience in the non-profit industry, the Enkel team offers a unique bookkeeping solution for NPO’s that want to optimize their day-to-day bookkeeping and have an accurate set of books through the year. If you would like to learn more about our services for not-for-profit organizations, get in touch today for a free consultation!