Fund Accounting Basics for Nonprofits and Governments

Fund accounting is a system that tracks money by the purpose it was given for rather than by the profit it generates. Nonprofit organizations and state and local governments use it to prove that every dollar went where donors, grantors, or the law intended. The rules come from two separate standard-setters: the Financial Accounting Standards Board (FASB) writes the standards for non-governmental nonprofits, and the Governmental Accounting Standards Board (GASB) writes them for state and local governments.¹ Whether you sit on a board, manage a grant, or just want to read a charity’s financial statements, the ideas below are the ones that matter.

Why the System Exists

Commercial accounting exists to measure profit. Assets equal liabilities plus equity, and everything feeds a single net income figure that tells shareholders whether the business made money. Fund accounting flips that priority. The equation becomes assets equal liabilities plus net assets (for nonprofits) or fund balance (for governments), and the point is to demonstrate that restricted resources stayed restricted.

The practical difference is this: a company pools its cash and spends it wherever returns look best. A nonprofit that receives a grant earmarked for literacy programs cannot redirect that money to cover a shortfall in its food bank, even if both activities serve the mission. Fund accounting enforces that wall by segregating resources into separate pools, each one a self-balancing set of accounts. It’s also why a nonprofit can report millions in assets and still struggle to pay the electric bill. Most of the money is locked into specific purposes.

How Nonprofits Classify Their Resources

Under FASB’s current standard, ASU 2016-14, nonprofits sort all resources into two classes of net assets, down from three under the older FAS 117.²

Net assets without donor restrictions. Resources that carry no external strings. General operating revenue, fee-for-service income, and amounts the board itself has designated for a purpose all sit here. A board designation is not the same as a donor restriction, because the board can reverse its own decision at any time.
Net assets with donor restrictions. Resources that a donor or grantor has earmarked for a specific purpose, a specific time period, or both. This single category now holds what the old rules split into “temporarily restricted” and “permanently restricted.” Permanent endowments, where the principal must stay intact and only the earnings can be spent, go here alongside time-limited grants and purpose-restricted gifts.²

Statements must show amounts for each class separately, so a reader can see immediately how much of the organization’s wealth is actually available for discretionary spending.

How Governments Classify Fund Balance

Government accounting under GASB Statement No. 54 uses a more granular system called fund balance, sorted into five tiers based on how strong the spending constraint is.³ The hierarchy runs from most constrained to least:

Nonspendable. Resources that can’t be spent because of their form (inventory, prepaid items) or because they must be kept intact (permanent fund principal).
Restricted. Amounts that can be spent only for purposes imposed by external parties such as creditors, grantors, or other governments, or through constitutional provisions and enabling legislation.³
Committed. Amounts locked in by a formal action of the government’s highest decision-making authority, typically the full legislative body. Undoing a commitment takes the same level of formal action that created it.
Assigned. Resources intended for a specific purpose but without that formal commitment. In funds other than the general fund, assigned is the default classification for any remaining amount that isn’t restricted or committed.³
Unassigned. The residual classification for the general fund only. This is the true “available for anything” money. In other governmental funds, unassigned amounts appear only when spending has exceeded restricted, committed, or assigned amounts, leaving a deficit.

If you’re sizing up a government’s financial health, look at unassigned fund balance in the general fund. That number tells you how much breathing room the government actually has.

When Revenue and Expenses Get Recorded

Fund accounting uses two different timing rules depending on the entity and the type of fund.

Full Accrual

Nonprofits use full accrual across the board. So do governmental proprietary funds (such as water utilities) and fiduciary funds (such as pension trusts). Revenue is recorded when earned and expenses when incurred, regardless of when cash changes hands. A nonprofit that sends an invoice in December records the revenue in December, even if payment arrives in February.

Modified Accrual

Governmental funds — the general fund, special revenue funds, capital project funds, debt service funds, and permanent funds — use modified accrual. This hybrid focuses on current financial resources, meaning the cash and near-cash assets available to pay current obligations.

Revenues are recognized only when they are both measurable and available. “Available” generally means the government expects to collect the money soon enough after the fiscal year ends to pay liabilities from that year. Property tax revenue, for example, must be collectible within a short window after fiscal year-end to count as that year’s revenue.

Spending under modified accrual is recorded as “expenditures” rather than “expenses,” and the distinction matters. When a government buys a building, the full purchase price hits the books as a current-year expenditure. There is no capitalization and no depreciation schedule the way you’d see in commercial or full-accrual accounting. The measurement focus is on what financial resources flowed in and out during the period, not on the long-term economic picture.

Encumbrances: Reserving Budget Before You Spend It

Governments operate under legally adopted budgets that cap spending by category, a constraint most nonprofits do not face. Encumbrance accounting exists to prevent overspending those appropriations. When a government issues a purchase order, the committed amount is immediately recorded as an encumbrance, a reservation against the budget, even though no payment has been made and no goods have arrived.

Think of it as earmarking. If a department has a $500,000 supply budget and issues a $50,000 purchase order, the encumbrance system instantly reduces the available balance to $450,000. Without that step, a manager checking the budget might see $500,000 as available and unknowingly authorize spending that pushes the department over its legal limit.

When the vendor delivers and the invoice is paid, the encumbrance is reversed and replaced by an actual expenditure entry. Encumbrances still open at fiscal year-end typically carry forward to the next year as reserved amounts. It’s one of the clearest practical differences between governmental fund accounting and the commercial accounting most people learn first.

How Restricted Contributions Are Recorded and Released

Contributions are the lifeblood of most nonprofits, and they follow specialized recognition rules because they are non-exchange transactions, meaning the donor gets no direct economic benefit in return. FASB requires nonprofits to recognize contributions at fair value when received, or when an unconditional promise to give is made.⁴

Conditional vs. Unconditional Promises

An unconditional pledge (“I will give your organization $100,000 next year”) gets recorded right away as revenue and a receivable, even though cash hasn’t arrived. A conditional promise stays off the revenue line until the condition is met. For a promise to be conditional, it must include both a barrier the nonprofit has to overcome and a right of return or release if the barrier isn’t met.⁴ Until the condition is satisfied, the funds sit on the books as a refundable advance, essentially a liability.

When donor stipulations are ambiguous, the default treatment is to presume the contribution is conditional. An organization that aggressively books conditional grants as revenue will overstate its financial position and may end up spending money it has to return.

Releasing the Restriction

Revenue received with a donor restriction is first recorded in net assets with donor restrictions. It stays there until the restriction is satisfied, either by spending the money on the designated purpose or by the passage of the required time period. At that point the organization records a reclassification, moving the amount from restricted to unrestricted net assets. If a donor gives $50,000 for new computers, the restriction releases when the computers are purchased. A time restriction lifts when the specified date or fiscal year arrives. This two-step recognize-then-release process is the core mechanism that makes fund accounting work for restricted gifts.

What the Financial Statements Look Like

FASB requires nonprofits to produce three primary financial statements:²

Statement of Financial Position. The nonprofit equivalent of a balance sheet. It reports total assets, total liabilities, and the two classes of net assets (with and without donor restrictions). It tells you what the organization owns, what it owes, and how much of its net wealth is tied up in donor-imposed purposes.
Statement of Activities. The equivalent of an income statement, but instead of a single bottom-line profit figure it shows the change in each class of net assets during the period. You can see how much unrestricted revenue came in, how much restricted revenue was received, and how much was released from restriction, all in one place.
Statement of Cash Flows. Tracks actual cash moving in and out, categorized as operating, investing, or financing activities. Accrual-basis statements can hide cash problems; a nonprofit with strong revenue growth on the Statement of Activities might still be running out of cash.

ASU 2016-14 also added a liquidity disclosure. Nonprofits must provide both qualitative and quantitative information about the availability of their financial resources, essentially explaining how much cash and liquid assets are available to cover operating needs over the next year once donor restrictions and internal designations are accounted for.² The disclosure addresses a long-standing complaint that nonprofit balance sheets made it hard to tell whether an organization could actually pay its bills.

Every nonprofit must also present an analysis showing expenses broken down by both function (program services, management and general, fundraising) and nature (salaries, rent, supplies, depreciation).² The older rules required this only of voluntary health and welfare organizations; the current rules extend it to the entire sector. Donors and watchdog groups use the resulting program-to-total spending ratio as one of their main metrics for judging efficiency.

When Federal Funding Triggers an Audit

Any non-federal entity, nonprofit or government, that spends $1,000,000 or more in federal awards during its fiscal year must undergo a single audit under the Uniform Guidance.⁵ A single audit is a specialized engagement that goes beyond standard financial statement auditing to test whether federal funds were spent in compliance with program requirements.

Organizations that spend less than $1,000,000 in federal awards are exempt from the single audit requirement, though they must still keep records accessible to federal agencies and the Government Accountability Office.⁵ The audit must be performed by an independent auditor, and findings of noncompliance can lead to repayment demands, funding suspensions, or disqualification from future awards.

Fund accounting makes single audits manageable by keeping each federal grant in its own segregated fund. Without that segregation, tracking expenditures across dozens of federal programs and matching each dollar to the right compliance requirement would be far more error-prone. Organizations approaching the $1,000,000 threshold should factor the cost and administrative burden of a single audit into their grant-acceptance decisions, since the audit itself can run tens of thousands of dollars depending on the number of federal programs involved.

1
Financial Accounting Standards Board. Not-for-Profits
2
Financial Accounting Standards Board. Accounting Standards Update No. 2016-14
3
Governmental Accounting Standards Board. Summary – Statement No. 54
4
Financial Accounting Standards Board. Not-for-Profit Entities (Topic 958)
5
eCFR. 2 CFR 200.501 – Audit Requirements