While the accounting systems used by commercial businesses and Non-profit Organizations (NPOs) share plenty of similarities, the critical difference lies in their sources of revenue. In commercial enterprises, revenue comes from either sales or profits from investments. In non-profit organizations, revenue is a combination of sales or investments plus contributions. Donations are usually so significant that without them, the NPO would not be able to operate.
Non-profit organizations must also differentiate between contributions and all other sources of revenue, as contributions can often come with restrictions on their usage. In Canada, many NPOs track and report on their finances using fund accounting to separate these differing revenue streams.
Fund accounting is an accounting system that uses the restricted fund method to help distinguish between restricted and unrestricted contributions in financial reports. Contributions can be restricted or unrestricted and can be tracked using the deferral method 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. It is often used by small organizations with unrestricted contributions. The fund method of accounting is more complex and requires more effort to prepare and maintain. This method is preferable for larger organizations with multiple restricted contributions.
An organization doesn't need to follow either accounting method to track contributions; however, using one over the other can have a significant impact on the organization.
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 a clear division of revenues, making it a good choice for organizations with diverse funding sources.
Tracking Contributions
Revenue for non-profits can come from various sources, including donations, fees for service, event ticket sales, grants, membership purchases and renewals, and investments.
Donations, also called contributions, are typically the biggest revenue driver for non-profit organizations, but this type of financial support can come with stipulations designated by the donor.
Donations can also take the form of pledges, representing a future monetary commitment; bequests 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 Funds Based on Restriction Types
At a high level, contributions are either unrestricted or restricted. Only the donor can determine whether a donation is restricted and specify whether that restriction is temporary or permanent.
Unrestricted contributions can be used for any purpose by the NPO and are often applied to administrative or operational costs.
Contributions can be temporarily restricted by time, purpose, or location. The restriction period must elapse before the contributions become unrestricted and can be used however the organization sees fit.
Contributions 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 NPO invests in the principal and can only spend the interest generated by the principal. The principal can only be used for specific activities or projects designated by the fund.
In the simplest form of fund accounting, organizations will have two funds: unrestricted and restricted funds. 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 by the organization's board.
Non-profit Fund Accounting Financial Statements
Non-profit organizations 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.
Key Considerations For Internally & Externally Restricted Funds
Use this list to review your organization’s restricted funds and prepare for any questions that your board or auditors might have.
Download The ListThe Future of Fund Accounting
The Accounting Standards Board (AcSB) is engaged in ongoing research into how revenue from contributions should be tracked and reported by non-profit organizations. Specifically, the Board plans to examine current accounting practices among organizations, 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 organizations 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 charitable sector, the Enkel team offers a unique bookkeeping solution for not-for-profits 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!
