This post was last updated on May 26th, 2022 at 11:54 am.
That sounds like a simple question, right? But it’s not. If a nonprofit organization doesn’t know what to look for, they could choose an accounting system that fails them when they need it. The goal of this post is to briefly go over what government regulations say about fund accounting, the main ideas of fund accounting, and what to watch out for.
Fund Accounting is Not a Popularity Contest
Although fund accounting gives nonprofits the best picture for each purpose, it certainly is not the popular choice. Fund accounting emphasizes accountability, more than profitability – as a for-profit system does. Additional steps are required to enter transactions in fund accounting. And to be frank, most people run when they hear anything with the word accounting, let alone fund accounting.
Let’s get two unpopular truths out of the way.
- Fund accounting is required for all nonprofit organizations – churches included, by law (FASB Topic 958). Churches – no matter the size, must use fund accounting and there are no exceptions.
- Fund accounting is more complicated than basic accounting, or for-profit accounting.
This is probably why many organizations go down the wrong path. After all, even CPAs and other experts guide churches into using the wrong fund accounting software. So what’s an organization to do to lessen the confusion and keep themselves out of trouble? Educate, they have to dig in and learn the principles of fund accounting forward, backward, up, and down. This helps so you know that the chosen software will make your life easier, and can actually perform to the standards and adhere to the law. Having software that bends (or breaks) the law is of no use to a church.
Spoiler alert: Quickbooks does not adhere to FASB guidelines Topic 958 which is the law in the USA. Thus Quickbooks, while it may be the standard in for-profit businesses, is not the standard in a nonprofit organization, such as a church.
Why for-profit systems do not work in churches
Simply put, there is no for-profit system that can be set up as a nonprofit system. Why? Because the overarching architectural foundations of both software systems are completely different. It would be like trying to put the body of a Volkswagen Bug on a Chevy Truck frame. A for-profit system is not designed to handle nonprofit accounting. This is why many for-profit systems like Quickbooks use workarounds, like classes, which only go so far. It is an incomplete solution because they still can’t break the assets down by classes, only the revenue, and expenses.
The Basic Fund Accounting Concept
Fund accounting emphasizes accountability over profitability. Accountability to who, or what? Good question. It shows accountability to each purpose or mission within the larger organization. To compare fund accounting with for-profit accounting, let’s summarize each. In a for-profit business they want to know how much was spent, how much was earned, and finally how much is left over. Nonprofits using fund accounting, still want to know all of these, but broken down by purpose. Fund accounting provides mini financial statements for each purpose or mission. These statements give you accountability on how each mission (purpose) is doing financially.
What is ‘purpose’ within the context of fund accounting?
How do you decide what the purpose (or mission) is? The purpose or mission can be designated, grants, departments, campaigns, unrestricted, and so on. The question to ask yourself is “Do I need to know how much money I have set aside for ________?” A question such as, “how much money do we have for the Haiti Relief mission” would indicate you need a fund.
Keeping things simple in accounting should be one of the goals when setting up the system’s funds and accounts. Typically, the more funds you have the more complicated the data entry becomes. Let’s further explore the Haiti Relief example to illustrate this. If the church has several missions around the world, they can certainly make a fund for each mission. Depending on the number of missions, this can become complicated. In a true fund-based accounting system there is a give and pull when it comes to these types of scenarios. Instead of using several funds to define the various global missions, let’s see how it might get set up using one fund called Global Missions.
The church would create one fund called Global Missions which tracks all the money coming in and out for all the global missions. Within this fund, you can further break it down with some revenue and expense accounts. Something like Haiti revenue and Haiti expense. Then have a Peru expense and Peru revenue. This allows creating financial statements for the Global Missions fund, which will have the monies further broken out in revenue and expenses. Additionally, the Global Missions fund balance sheet will show the assets and liabilities. This gives greater flexibility in certain circumstances and keeps your funds condensed, but still provides the necessary information.
When to use Fund Accounting
In a church, you will use fund accounting every day. Let’s show an example of when it is used. The church currently has $5,000.00 in the checkbook for the General Fund. Up until now, the church has only had one unrestricted fund. The church receives a large donation (1 million) to add to the church building. The donor has restricted this money and given it the ‘purpose’ that it must be used for.
How is the church going to keep this money separate from the General Fund monies? You could open up another checkbook, but what happens when the next restricted donation comes in? Are you going to open up another checkbook? Eventually, like many churches we see, they have five to ten checkbooks and do monthly reconciliations for each one. That must be tiring! Is there a better way? YES, there is… fund accounting!
The church would deposit the money into the same checking account as the General Fund, thus keeping monthly reconciliations to one. But they would ‘tag’ it with a different accounting fund, like Building Fund. This allows the software to separate the monies into different financial statements, one for the General Fund and one for the Building Fund. Think of it this way: the software reviews the transactions like deposits, expenditures, and journal entries and each of their fund ‘tags’. Then, based on that tagging, the software places each transaction into separate cookie jars. It uses each cookie jar to prepare the financial statements based on those transactions.
In a proper accounting setup, each fund would have its own assets, liabilities, income, and expenses. This makes it a completely separate entity within your organization. With that separation comes its own financials that the church can review and see exactly how the mission (purpose) is doing. For-profit systems like Quickbooks cannot do this properly, instead, they use workarounds like classes and liabilities.
Why Use Fund Accounting?
There are many reasons, but let’s get the red tape out of the way. If you are a nonprofit you are required by law to use it, without exception. To extend it further, every organization must use some accounting system to understand how it’s doing financially.
Why do churches have to use such a complex system, when for-profit businesses can use a simpler system? It comes down to the tax exemption status that churches enjoy. The government is giving you a huge break on taxes, thus you need to prove to them that your mission benefits humanity (ie. the community). After all, the whole reason nonprofits get these benefits is they have demonstrated to the government that the world is a better place when they accomplish their missions.
The last reason is for your donors. Fund accounting shows the transparency to your donors and the status of the current mission(s). This is so important for donors to be able to understand how they may help, how well the mission is going, and if they should make a decision to increase their offerings. Donors often give to successful missions and projects. They tend to withhold resources if they see failure or worse yet, abuse of resources.
Using Accounts to Define Funds is Wrong!
Sometimes to define something, like fund accounting, you have to say what it is not. Many systems try various ways to work around the fund accounting issue, but ultimately fail. Here, we will go over some of the more common scenarios using accounts for funds.
Using liabilities to define funds… Is Wrong!
Fund accounting should never use liabilities to manage fund balances. A liability is something an organization (or person) owes to someone else. Placing the Youth Fund money in a liability account doesn’t make sense. The Youth Fund has money. It’s not a liability, yet it is done every day in churches when they use Quickbooks or another accounting system that does not adhere to fund accounting principles.
Using multiple sub-accounts in a checkbook… Is Wrong!
When churches are forced to use sub-accounts in their checkbook to keep their money separate, it creates a lot more work for them via the monthly checkbook reconciliations. It also does not reflect reality. They don’t have that many accounts at the bank. Their chart of accounts should mimic real life as much as possible. It also does not keep the church from moving money from a restricted to an unrestricted checking account. This is a big no-no in church accounting. In fact, the church can be held legally responsible, based on contract law, to pay the entire donation back plus punitive damages if they do not adhere to the restrictions placed on it.
Using classes on revenues and expenses… Is Wrong!
Another way some software systems try to get around fund accounting principles is by using classes. For this to work, classes have to be used throughout the five areas within the chart of accounts – ie the assets, liabilities, equity, income, and expenses. However, in a software package that uses classes, this is not the case. Classes are only used in the income and expense accounts, but not the asset and liability accounts. Worse yet, their equity accounts do not break down into these classes. Because of this, the balance sheet will never be right; balance sheets show assets and liabilities which are not covered by classes.
Using multiple bank accounts to define funds… Is Wrong!
There is no need for multiple checking accounts. Most of the time a nonprofit organization can use one checkbook. There is one exception which is an endowment gift. This may need its own interest-bearing account because the monetary gift will have certain restrictions. One restriction is that the principal is invested in an investment style account, which different than a normal checkbook. This limitation is due to the banking industry’s regulatory rules, not fund accounting.
In the past, before software had the capability, churches would open up multiple bank accounts, one for each purpose (mission). At the time this was necessary to keep the money separate, although not required by banking rules or FASB. There just was no better way to track the money as it was received or spent, by the church. Simply put, the software was not yet available to show the separation of monies.
Funds should never be defined as accounts, classes, or liabilities
As we reviewed why funds should not be multiple checking accounts, classes, or liabilities — it should become apparent that any system that uses these types of workarounds is simply shortchanging the church by not doing it right. Ultimately, the church is responsible for the software they choose. In other words, when the church comes up short and can’t provide the reports per FASB standards, you risk losing your tax-exempt status. What is worse, is that the church loses transparency with its donors, which breaches their trust.
Fund Accounting Summary
In this post, we reviewed that fund accounting is not a popularity contest. It is not the easiest concept or method of accounting. In fact, most would argue it is probably the most difficult accounting method. However, t accounting method is the only one that emphasizes accountability, and the only method that is legally allowed for nonprofits such as churches.
We also defined what ‘purpose’ is in the context of fund accounting and how each purpose (mission) must have its four areas of accounts — assets, liabilities, income, and expenses. In essence, each purpose has its own self-balancing accounts. We then went over the reasons why multiple checking accounts, liabilities, and classes should never be used to replace funds. We hope by defining what fund accounting is, and what it is not, that you walk away with a better understanding of fund accounting.
When the church is ready to use a real fund accounting system, check out IconCMO. IconCMO was reviewed by one of the top 25 accounting firms in the country.