Fund Accounting for Nonprofits: Best Practices

Nonprofit accounting is fundamentally different from for-profit accounting in one crucial respect: the goal is not to generate profit for owners, but to deploy resources in service of a mission — and to demonstrate to donors, grantors, regulators, and the public that you have done so responsibly and in accordance with any restrictions placed on funds.

Fund accounting is the system nonprofits use to track resources that are restricted to specific purposes, programs, or time periods, separately from unrestricted resources available for general operations. Without proper fund accounting, a nonprofit cannot demonstrate grant compliance, cannot produce the financial statements required for Form 990, and cannot give its board the information it needs to make sound stewardship decisions.

Key Takeaways

• Nonprofit financial statements use net asset classifications: net assets without donor restrictions and net assets with donor restrictions (time-restricted or purpose-restricted)
• Form 990 is the primary annual compliance filing for nonprofits — it is public, and major donors and watchdog groups read it
• The statement of functional expenses is a required disclosure for health and human services organisations and highly recommended for all nonprofits
• Functional expense allocation (program, management/general, fundraising) requires a documented, defensible methodology
• Grant accounting requires tracking each grant separately: cash received, expenses charged, matching requirements, and reporting deadlines
• In-kind contributions (donated goods, services) must be recorded at fair value if they meet recognition criteria
• Single audit (OMB Uniform Guidance) is required if you expend $750,000+ in federal awards in a fiscal year
• Board-designated funds are technically unrestricted — only donor-imposed restrictions create restricted net assets

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The Nonprofit Financial Statement Framework

Nonprofits present four primary financial statements, which differ from the for-profit balance sheet/income statement structure:

1. Statement of Financial Position (Balance Sheet equivalent)

Assets, liabilities, and net assets. Net assets are classified as:

• Net assets without donor restrictions (formerly "unrestricted")
• Net assets with donor restrictions (formerly "temporarily restricted" and "permanently restricted" combined, then disclosed by type)

2. Statement of Activities (Income Statement equivalent)

Revenues, gains, expenses, and changes in each net asset class. Revenues are classified by whether they are restricted or unrestricted. Expenses are reported only in the without-donor-restrictions column (expenses reduce unrestricted net assets, not restricted ones — restricted funds are "released from restriction" when the restriction is met, transferring from restricted to unrestricted before being spent).

3. Statement of Cash Flows

Same three-section format as for-profit (operating, investing, financing), typically prepared using the indirect method.

4. Statement of Functional Expenses

Required for voluntary health and welfare organisations, strongly recommended for all nonprofits. Shows expenses classified by natural category (salaries, rent, supplies) in columns, and by functional category (program services, management/general, fundraising) in rows.

The release from restriction mechanism:

When a donor restricts a gift for "youth programs," you record the gift as restricted revenue. You spend the money on youth programs. When you spend it, you record a "satisfaction of purpose restriction" release: debit Net Assets — Restricted, credit Net Assets — Unrestricted. Then debit the expense and credit cash as normal. The expense appears in the without-donor-restrictions column, matching the purpose the donor intended.

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Net Asset Classifications in Practice

Without donor restrictions:

Most operating revenue (membership dues, event revenue, service fees, general donations) is unrestricted. Board-designated funds — where the board sets money aside for a specific purpose — remain without donor restrictions because only donor-imposed restrictions create restricted net assets. A board can un-designate its designated funds at any time; a donor-imposed restriction cannot be released except as specified.

With donor restrictions — time-restricted:

A pledge to pay $50,000 over five years (first year payment due July 1, years 2–5 to be paid in future years) creates a time restriction. The present value of the full pledge is recorded as restricted revenue when the pledge is received, with the restriction releasing as each payment becomes due.

With donor restrictions — purpose-restricted:

A grant of $200,000 to build a new computer lab creates a purpose restriction. The funds are restricted until spent on the computer lab. If you receive the full $200,000 upfront and spend $75,000 this year, $125,000 remains in restricted net assets at year end.

Permanently restricted (endowments):

Donor-restricted endowments create permanently restricted net assets — the principal is maintained in perpetuity. Only the income generated by the endowment corpus (investment returns) is available, and may itself be time- or purpose-restricted. Account for endowment activity under your state's Uniform Prudent Management of Institutional Funds Act (UPMIFA) provisions.

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Grant Accounting: Setup and Compliance

Grant accounting is the most technically demanding aspect of nonprofit financial management. Each grant has unique: budget line items, eligible and ineligible expenses, matching requirements, indirect cost rates, reporting periods, and closeout requirements.

Setting up a new grant:

1. Create a project or cost centre code for the grant in your accounting system
2. Enter the full grant budget by line item
3. Document indirect cost rate agreement (federally negotiated rate or de minimis 10% MTDC)
4. Set up budget tracking to monitor spending against grant budget
5. Create a calendar reminder for all reporting deadlines (financial and programmatic)
6. Identify cash management requirements — draw-down system or reimbursement basis

Allowable and unallowable costs:

Federal grants (and many foundation grants) specify categories of costs that are allowable. Under OMB Uniform Guidance (2 CFR 200), common unallowable costs include: entertainment, alcohol, lobbying activities, fines and penalties, bad debts, and certain executive compensation above the IRS benchmark. Ensure your chart of accounts separates unallowable cost categories so you can easily exclude them from grant billings and reports.

Matching requirements:

Many grants require a cost-sharing or matching commitment — typically 25–50% of the total project cost from non-federal sources. Match can be cash (unrestricted funds you spend on the project) or in-kind (volunteer time at fair value, donated goods, space use). Track matching contributions by grant in your accounting system with the same rigour you apply to grant expenses. Failure to meet matching requirements jeopardises future funding.

Draw-down procedures for federal grants:

Most federal grants are managed through the Payment Management System (PMS) or grantor-specific systems. Draw down funds only for actual cash needs — drawing down more than needed creates interest income obligations (you must remit interest on federal funds over $500 held more than one business day). Reconcile every draw-down to expenses incurred in the corresponding period.

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Functional Expense Allocation

The statement of functional expenses requires you to classify all expenses by both nature (what you spent on) and function (why you spent it). The functional categories are:

Program services: Activities that fulfil the organisation's mission. If you run job training, youth programs, and housing assistance, each is a separate program service category.

Management and general (M&G): Administrative activities that support the overall organisation but are not specific to any program or fundraising. Includes CEO/CFO time, board governance, general accounting, legal, and facilities used by all departments.

Fundraising: Activities to solicit contributions. Includes development staff, grant writing, direct mail campaigns, gala events (the fundraising portion), and donor relationship management.

Allocation methodology:

Expenses that clearly belong to one function are charged directly. Joint costs — those that serve multiple functions — must be allocated using a systematic and rational method. Common allocation bases:

Time study requirements:

For salary allocation, maintain time studies — either actual timesheets by functional category or periodic allocation studies that document how staff members split their time. A program director who spends 80% on program delivery and 20% on grant writing has their salary allocated 80% to program and 20% to fundraising. Update time studies annually or when roles change significantly.

The 75%+ program ratio benchmark:

Watchdog organisations (Charity Navigator, GuideStar, Better Business Bureau Wise Giving Alliance) assess nonprofits partly on the percentage of expenses going to program services. The common benchmark is 75% or higher. If your functional allocation methodology is sound and your allocation of joint costs is defensible, you will naturally achieve a fair representation of your program ratio.

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In-Kind Contributions

Donated goods, services, and use of facilities can significantly affect a nonprofit's financial picture and should be recorded when they meet recognition criteria.

Recognition criteria (ASU 2018-08 / ASC 958):

An in-kind contribution is recognised when: the fair value can be reasonably determined AND the donation would typically need to be purchased if not donated.

Donated professional services:

Recognise when the services: (1) create or enhance a nonfinancial asset, OR (2) require specialised skills, are provided by individuals possessing those skills, and would typically be purchased if not donated.

Examples that qualify: a CPA providing pro bono audit services, an attorney providing legal advice, a construction firm donating renovation work. Examples that typically do not qualify: general volunteer labour (unless it replaces work that would otherwise be purchased).

Record at fair value — what you would have paid for the same service in the open market. Debit an expense account (professional services, facilities, etc.) and credit in-kind contribution revenue. The net effect is zero, but both revenue and expense are properly disclosed.

Donated goods:

Value at fair value (selling price in the market where you would normally purchase similar goods). A donation of 500 laptops is valued at the current market price for comparable used laptops, not the original retail price or the donor's book value.

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Form 990 Preparation and Compliance

Form 990 is a public document. Any person can request it from the IRS or access it via ProPublica Nonprofit Explorer or GuideStar. Major donors, foundation program officers, and investigative journalists read Form 990s. Accurate, transparent, and professional 990 preparation is both a compliance requirement and a reputation management imperative.

990 filing thresholds:

Key 990 schedules:

• Schedule A: Public support test calculation (organisations must demonstrate broad public support to maintain public charity status)
• Schedule B: Schedule of Contributors (major donors above the threshold)
• Schedule D: Supplemental financial statements (endowment reconciliation, conservation easements)
• Schedule F: Activities outside the US (foreign grants, foreign bank accounts)
• Schedule G: Fundraising activities and gaming
• Schedule H: Hospitals only — community benefit reporting
• Schedule L: Transactions with interested persons (board members, key employees, related parties)
• Schedule O: Supplemental information (explains many narrative questions on the core form)

Compensation disclosure:

Form 990 Part VII requires disclosure of compensation paid to officers, directors, key employees, and the five highest-compensated employees earning over $100,000. This is fully public. Ensure compensation is set through a comparability data process (documented board approval using salary surveys) to satisfy the rebuttable presumption of reasonableness under IRC 4958.

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Single Audit Requirements

Nonprofits that expend $750,000 or more in federal awards in a fiscal year must undergo a Single Audit (formerly A-133 audit) in addition to their regular financial statement audit.

What a Single Audit tests:

• Financial statements (same as regular audit)
• Internal controls over federal programmes
• Compliance with federal programme requirements for each major programme

Major programme determination:

The auditor determines "major programmes" based on total federal expenditures using a risk-based approach. Organisations with large federal awards from a single programme (e.g., a Head Start grantee) will almost certainly have that programme as a major programme tested.

Preparing for a Single Audit:

Maintain a Schedule of Expenditures of Federal Awards (SEFA) — a complete listing of all federal awards expended during the year, including: CFDA number, federal agency, pass-through entity (if any), award identification, and total expenditures. Reconcile the SEFA to your general ledger quarterly, not just at year-end.

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Frequently Asked Questions

What is the difference between a fund balance and net assets?

Fund balance and net assets are essentially the same concept — the difference between assets and liabilities — but the terminology differs. Traditional fund accounting used "fund balance" to describe equity within each fund. Modern nonprofit accounting (following FASB ASC 958) uses "net assets" classified by donor restriction. Many nonprofits still use fund-based internal tracking (separate funds for each program, grant, or restricted purpose) while presenting the FASB-required net asset classifications in external financial statements.

Can board-designated funds be used for any purpose?

Yes — that is what makes them "without donor restrictions." The board designates funds internally for strategic purposes (building reserve, equipment replacement, operating reserve), but these designations are decisions the board can reverse. If the organisation faces a cash crisis, the board can vote to use the designated fund for operating purposes. Donor-restricted funds, by contrast, cannot be redeployed without donor consent or meeting the restriction's terms.

How do I handle a grant that requires program income to be returned to the grantor?

Program income (fees charged to participants in a federally funded program, for example) may be subject to grantor requirements — some grants require that program income be added to the grant budget, deducted from grant draws, or returned to the grantor. Review your award terms carefully. Record program income separately in your accounting system with the grant project code. Treat it according to the grant terms — if it reduces draws, your next draw-down should be reduced by the program income received.

What are the consequences of not filing Form 990 on time?

The penalty for late filing is $20/day for organisations with gross receipts under $1 million, and $100/day (up to $50,000) for larger organisations. More significantly, failing to file for three consecutive years results in automatic revocation of tax-exempt status. Reinstatement after revocation requires a new application (Form 1023 or 1024) and a reinstatement fee, and you cannot receive tax-deductible contributions during the revocation period.

How should a nonprofit account for a multi-year grant?

If a multi-year grant has unconditional payment promises (the grantor commits to all years upfront), record the present value of all future payments as revenue in the year of the grant award. The discount creates a discount on pledges receivable. Accrete the discount to interest income over the pledge period. Each year's actual payment reduces the pledge receivable. If the grant is conditional (future payments depend on performance, reporting, or continued grantor discretion), recognise revenue only as conditions are met.

What internal controls are most important for nonprofits?

Critical controls include: dual signatures on disbursements above a threshold (typically $5,000–$10,000), board finance committee review of monthly financial statements, segregation of duties in cash handling (different people authorise payments, record transactions, and reconcile bank accounts), documented grant expense review by a financial staff member different from the programme staff who incurred the costs, board approval for any transactions with interested parties, and annual independent audit or review.

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Next Steps

Nonprofit fund accounting requires specialised expertise that combines accounting technical knowledge with understanding of nonprofit regulatory requirements, grant compliance, and the unique needs of mission-driven organisations. Many nonprofits rely on accounting staff without nonprofit-specific training, leading to compliance gaps, audit findings, and financial statement errors that damage credibility with funders and regulators.

ECOSIRE's accounting team provides nonprofit financial management support — from basic bookkeeping and grant tracking to Form 990 preparation, Single Audit readiness, and board-level financial reporting. We support nonprofits of all sizes, from community organisations with $200K budgets to regional nonprofits with multi-million-dollar federal grants.

Explore ECOSIRE Accounting Services to learn how we can strengthen your nonprofit's financial foundation and compliance posture.