What Is Fund Accounting? A Nonprofit Guide to Restricted vs Unrestricted Funds

If you have ever sat in a board meeting where someone asked “can we use that grant money for something else” and watched the room go quiet, you have already seen why fund accounting exists. It is not a fancier word for bookkeeping. It is a specific approach built around one job: proving that money donors and grantors gave for a particular purpose was actually spent on that purpose.

Executive Summary

Many nonprofit leaders, especially board members, new executive directors, and program staff, hear “fund accounting” and assume it is just a more complicated word for bookkeeping. It is not. It is a specific accounting approach built around accountability for restricted money, and misunderstanding it is one of the most common ways nonprofits end up in avoidable trouble with funders or auditors. Spending restricted money on the wrong thing, even accidentally, can mean returning funds to a grantor, failing an audit finding, or damaging a funder relationship.

Fund accounting means tracking your nonprofit’s resources by their source and purpose, not just by how much total cash is on hand. Separately, your audited financial statements classify resources into two net asset categories, with donor restrictions and without, under current accounting standards. These are related but not identical concepts, and conflating them is where a lot of confusion starts. Any nonprofit accepting restricted grants, program specific donations, or endowment gifts needs some form of fund accounting, regardless of size.

TL;DR

Fund accounting tracks nonprofit resources by source and purpose, not just total cash, because restricted money cannot be spent like unrestricted money. Under current accounting standards, nonprofit financial statements classify net assets into just two categories: with donor restrictions and without donor restrictions. This replaced the older three tier system of unrestricted, temporarily restricted, and permanently restricted. Internally, many nonprofits still track more granular funds, such as a specific grant, an endowment, or a building fund, for management purposes, even though external financial statements only show the two categories. Most nonprofits use accrual basis accounting for GAAP compliant, audit ready financial statements.

Key Takeaways

• Fund accounting and net asset classification are related but different things. One is an internal tracking method, the other is an external financial reporting requirement.
• The move from three restriction categories to two, effective for fiscal years beginning after December 15, 2017, was meant to reduce complexity, but many nonprofits, and even some published guides, still describe the old three tier system as current.
• A restricted grant does not just need to be spent correctly. It needs to be trackable well enough to prove it was spent correctly if a funder or auditor asks.
• Board members and program staff, not just the bookkeeper, need a basic understanding of restrictions. Most accidental misuse of restricted funds happens because someone outside the finance function did not know a restriction existed.

What Is Fund Accounting?

Fund accounting is a method of accounting used by nonprofits, governments, and other organizations whose purpose is accountability rather than profit. Instead of tracking one pool of money, fund accounting divides an organization’s resources into separate funds, each with its own purpose and its own rules about how it can be used. A fund is not necessarily a separate bank account. It is an accounting designation that says, in effect, this portion of our resources can only be used for a specific thing.

Fund Accounting vs For Profit Accounting: What Is Actually Different?

A for profit business tracks money primarily to answer one question: is this profitable? A nonprofit’s board, funders, and the IRS care about a different question: was this money used the way it was supposed to be? Fund accounting is built around that second question. It does not replace normal bookkeeping, since accounts payable, payroll, and bank reconciliations still work the same way. It adds a layer on top that segments resources by restriction and purpose, so an organization can prove, at any point, that restricted money has not been spent on the wrong thing.

How Many Funds Does a Nonprofit Actually Need?

There is no fixed number, and this is where a lot of nonprofits either over complicate or under complicate their books. Commonly used fund categories include the following.

• General or unrestricted operating fund: day to day resources with no donor imposed restrictions.
• Restricted funds: resources donors or grantors have designated for a specific purpose, program, or time period.
• Endowment funds: typically donor restricted gifts where the principal is meant to be preserved, often invested, and only the income or a portion of it is spent.
• Capital or plant funds: resources designated for a building, major equipment, or capital project.
• Agency or custodial funds: money the nonprofit holds on behalf of another organization or individual, which is not really the nonprofit’s own resource at all.

A small nonprofit with one general operating account and the occasional small restricted gift typically does not need a complicated multi fund structure. A well designed chart of accounts with classes or tags for each restriction is usually enough. A nonprofit actively managing several government grants, an endowment, and a capital campaign at the same time needs a more deliberate structure, because the risk of accidentally commingling restricted and unrestricted money goes up with every additional fund.

Net Assets With Donor Restrictions vs. Without: What Changed (and Why It Matters)

This is the part where a lot of otherwise good explanations of fund accounting go out of date, so it’s worth being precise.

What Are the Two Current Net Asset Categories?

Under FASB Accounting Standards Update (ASU) 2016-14, which took effect for fiscal years beginning after December 15, 2017, nonprofit financial statements classify net assets into two categories instead of three:

• Net assets without donor restrictions: resources available for general use, including amounts a board has internally designated for a specific purpose. Board designated funds are still technically “without donor restrictions,” since the board itself can change that designation.
• Net assets with donor restrictions: resources subject to donor imposed restrictions, whether those restrictions are expected to be satisfied by the passage of time, by a specific action (like spending on a defined program), or are intended to last in perpetuity (as with most endowments).

What Happened to “Temporarily” and “Permanently” Restricted?

Before this standard, nonprofit financial statements used three net asset categories: unrestricted, temporarily restricted, and permanently restricted. ASU 2016-14 combined “temporarily restricted” and “permanently restricted” into the single “with donor restrictions” category, with the underlying nature of each restriction disclosed in the notes to the financial statements instead of broken out as separate line items on the face of the statements. The standard also introduced new liquidity disclosure requirements and changed how restrictions on gifts for long lived assets are released.

You’ll still see plenty of articles, templates, and even some accounting software defaults using the older three category language. It isn’t wrong as a way of thinking about different types of restrictions, but it no longer reflects how the categories should actually appear on a GAAP compliant financial statement.

A Practical Example

(The following is a hypothetical scenario for illustration, not a description of an actual Breakwater client.)

Imagine a nonprofit receives a $75,000 foundation grant restricted to a specific job training program, on top of its normal individual donations and a small existing endowment. Internally, the bookkeeping team sets up a separate fund (or a class or tag within their accounting software) for the grant, so every expense charged against it, including trainer salaries, materials, and program specific overhead, can be reported back to the funder accurately and completely.

On the organization’s audited financial statements at year end, that grant doesn’t appear as its own line item. Whatever portion hasn’t yet been spent on the program is part of “net assets with donor restrictions,” with the specific nature of the restriction described in the footnotes. The internal fund tracking and the external net asset classification are doing two different jobs. One lets the program team and funder confirm the money was spent correctly; the other satisfies GAAP reporting requirements. A nonprofit needs both working correctly, not just one.

Does Fund Accounting Require a CPA?

Not necessarily for day to day bookkeeping. A bookkeeper or accounting staff member with nonprofit specific training can manage fund tracking, restricted fund tagging, and monthly reporting without being a CPA. Where a CPA typically becomes necessary is for the annual audit or review (if required by a funder, state law, or the $1 million federal Single Audit threshold), and for technical judgment calls, like how to classify a complex gift or when a restriction has been satisfied. Many nonprofits handle routine fund accounting internally or through an outsourced bookkeeping and controller relationship, and bring in a CPA specifically for the audit itself.

What Accounting Method Do Most Nonprofits Use?

Most nonprofits that need GAAP compliant, audit ready financial statements use accrual basis accounting, which records revenue when it’s earned (or a pledge is made) and expenses when they’re incurred, not just when cash changes hands. This matters for fund accounting specifically because grant revenue is often recognized when the grant’s conditions are met (for many government grants, as allowable expenses are incurred), not simply when the cash arrives. That can be counterintuitive for smaller organizations used to thinking in terms of their bank balance. Some very small nonprofits manage day to day on a cash or modified cash basis for simplicity, but shift to accrual basis reporting when an audit, a bank, or a major funder requires GAAP financial statements.

What Does a Fund Accountant Actually Do?

In practice, “fund accountant” isn’t always a separate job title at a small or midsize nonprofit. It’s a set of responsibilities that a bookkeeper, controller, or outsourced accounting team handles as part of normal monthly work. Those responsibilities typically include:

• Setting up the chart of accounts (often using classes, tags, or locations in software like QuickBooks Online) so income and expenses can be tracked by fund.
• Coding every transaction to the correct fund at the time it’s recorded, not reconstructed later.
• Monitoring restricted fund balances so spending never exceeds what’s available in a given fund.
• Preparing fund level reports for the board, program staff, or funders, showing not just what was spent, but what was spent from which fund.
• Working with the organization’s outsourced controller or CPA to make sure fund level detail rolls up correctly into GAAP net asset classifications at year end.

How Fund Accounting Shows Up in Your Everyday Bookkeeping

Fund accounting isn’t a separate system layered awkwardly on top of your books. Done well, it’s built into the chart of accounts and the way transactions get coded from day one. In QuickBooks Online, for example, this typically means using classes or projects consistently to tag every transaction to its fund, rather than trying to sort it out after the fact at year end. Breakwater’s guide to configuring QuickBooks Online for nonprofit fund accounting walks through that setup in more detail. This article is about understanding why that structure matters; that one is about how to actually build it.

Common Mistakes Nonprofits Make with Fund Accounting

• Commingling restricted and unrestricted cash in a single account with no way to tell them apart, which makes it nearly impossible to prove restricted money wasn’t spent on general operations.
• Coding transactions to the wrong fund after the fact, usually during a rushed month end close, which creates cleanup work and undermines confidence in fund level reports.
• Treating board designated funds as if they were donor restricted. A board can change its own designation; a donor restriction cannot be overridden by the board alone.
• Not tracking restrictions at all until an audit or grant report forces the issue, by which point reconstructing a year of activity by fund is far more expensive than tracking it correctly from the start.
• Assuming accounting software will handle this automatically. Most nonprofit capable software (including QuickBooks Online, configured correctly) can support fund accounting well, but it requires a deliberate chart of accounts and class structure. It doesn’t happen by default.

Final Thoughts

Fund accounting isn’t complicated because nonprofits make it complicated. It’s complicated because donors, grantors, and regulators genuinely do care about more than just your bottom line; they care about whether specific dollars were used the way they were supposed to be. Getting the structure right, meaning a chart of accounts built for fund tracking, consistent coding, and a clear understanding of the difference between internal fund tracking and external net asset reporting, is what turns fund accounting from a source of audit anxiety into a routine part of monthly bookkeeping.

If your nonprofit is managing restricted grants, an endowment, or multiple funding sources and isn’t confident your books could stand up to a funder’s questions today, Breakwater can help assess your current chart of accounts and fund tracking structure and recommend what needs to change. Schedule an initial call to talk through where your organization’s books stand today.

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