How Does Fund Accounting Work?

What Is Fund Accounting and How to Implement It

Accounting may seem like a rigid field – bound by laws and regulations, leaving little room for nuance or interpretation. But then you come across something called “fund accounting.”

How different is it from regular accounting? And why do some organisations require entirely different accounting systems? Here’s a hint right from the start: whilst charities and not-for-profits prioritise accountability, for-profit businesses focus on profitability. And that fundamental distinction changes everything about how accounting is approached.

What Is Fund Accounting?

Fund accounting is an accounting method used by charities and other not-for-profit organisations. These entities manage their income differently than regular companies, for the simple reason that their sources are mainly donations, grants, and legacies.

Since each source may come with specific conditions or restrictions, a generalised approach to accounting is insufficient. Fund accounting, therefore, is used to provide a structured way to segregate and track funds, ensuring that financial statements accurately reflect the organisation’s obligations and resources.

What Types of Organisations Need Fund Accounting?

TAs we have already mentioned, fund accounting is essential for organisations that manage multiple funding sources with specific restrictions. Key entities in the UK that rely on fund accounting include:

Not-for-profit Organisations

Not-for-profits, such as healthcare institutions and foundations, receive funding from multiple sources, each with distinct restrictions. Fund accounting helps them:

• Keep funds organised to ensure they are used as donors intended.
• Avoid mixing different funds together, since not-for-profit money must be used for specific purposes rather than as general income.
• Build trust by clearly showing how money is spent.
• Make it easier to track donations, grants, and contracts with simple, clear records.

Government Entities

Government bodies at federal, state, and local levels rely on fund accounting to:

• Allocate taxpayer money efficiently for specific projects, programs, and services.
• Segregate funds based on their designated purpose.
• Ensure fiscal responsibility and compliance with legal and regulatory mandates.

Educational Institutions

Schools, universities, and other educational institutions require fund accounting due to their diverse revenue streams, including:

The need for financial reporting that ensures funds are used for their intended educational purposes.

Tuition payments, grants, and donations, each requiring separate tracking.

Large endowments consisting of numerous donor-restricted gifts.

Types of Funds in Charity Accounting

At first glance, it may seem obvious whether a particular charity source of income has restrictions, but in practice, this is not always clear. To make sense of this, let’s break it down into four main types of charity funds:

1. Unrestricted Funds

• These funds come with no specific conditions attached.
• Trustees have full control over how they are spent, as long as the spending aligns with the charity’s objectives.

2. Designated Funds

• A subset of unrestricted funds that trustees have earmarked for a specific future purpose.
• Whilst still under the charity’s control, these funds are effectively “ring-fenced” for planned expenses.
• Common examples include setting aside money for redundancy costs or replacing key assets.
• Trustees can move money in and out of designated funds, but these decisions should be made before the financial year ends and properly documented.

3. Restricted Funds

• These funds come with specific conditions set by the donor or funding body.
• Money must be used only for the designated purpose – if not, there is often a requirement to return it.
• Restricted funds should be used within a reasonable timeframe to further a specific aspect of the charity’s mission, rather than the entire mission itself.
• If the funding benefits all aspects of the charity’s work, it may be classified as unrestricted instead.

4. Endowment Funds

• These funds must be invested or retained for long-term use rather than spent immediately.
• They can be either:
  • Expendable – Trustees have the discretion to spend some or all of the capital.
  • Permanent – The original donation must remain untouched, with only the investment income available for use.tsIQ can simplify this process, ensuring financial performance is easily monitored.

What Are the Benefits of Fund Accounting for Charities?

Specialised accounting has proven useful for UK Charities since it was introduced, helping them become more transparent with their donors and see an increase in funding in the past years.

For instance, the nation’s top 100 charities received nearly $64 billion in private contributions in 2024, marking a 4% annual increase – good fund accounting played an important role in this. Let’s take a look at other advantages fund accounting brings for charities:

1. Legal and Donor Compliance

• Many not-for-profit funds come with restrictions – some donations must be spent on specific programs or projects.
• Fund accounting ensures compliance with legal requirements and donor agreements.
• Misuse of restricted funds can lead to legal consequences or loss of donor confidence.
• As donations increase – in 2024, The Big Give’s Christmas Challenge raised a record £44.7 million from 119,000 donations for 1,250 charities – it is even more important for organisations to manage funds properly.

2. Better Financial Management

• Separating funds allows not-for-profits to plan their spending more effectively.
• It helps organisations avoid financial mismanagement, such as using money meant for one program to cover another.
• Not-for-profits can make better strategic decisions by understanding their available unrestricted and restricted funds.

3. Improved Budgeting and Financial Planning

• Many not-for-profits operate with limited budgets and need to carefully allocate their resources.
• Fund accounting allows for clear tracking of budgeted vs. actual spending, helping organisations stay on track.
• It also enables long-term financial planning by distinguishing between operational funds and capital funds (used for major projects or investments).

4. Better Decision-Making for Boards and Managers

• Not-for-profit boards and managers need reliable financial data to make informed decisions.
• Fund accounting provides clear reports that show financial health, funding gaps, and opportunities for growth.
• It enables leadership to adjust strategies based on real financial insights rather than assumptions.

5. Access to Funding and Credit

• Not-for-profits often rely on grants, donations, and loans for funding.
• Lenders and financial institutions assess an organisation’s financial health before providing credit.
• Strong financial reporting through fund accounting improves a not-for-profit’s ability to secure loans and funding.

6. More Effective Reporting to Stakeholders

• Not-for-profits must report their finances to donors, government agencies, and the public.
• Fund accounting allows for detailed and accurate reporting on how funds are used.
• It reassures supporters that their contributions are making an impact, encouraging future giving.and thus it is important to document how you meet these requirements.