6. Fund Accounting for Nonprofits: Funds, Net Assets
If you're running a nonprofit, or you just joined a board and got handed a stack of financial statements, the first thing you need to unlearn is how regular business accounting works. A normal company's books exist to answer one question: how much money did we make? Nonprofit books exist to answer a different question: did we use the money exactly how we promised? That's the whole ballgame, and it's why nonprofit bookkeeping has its own name: fund accounting.
Think of it this way. A business has one bottom line: profit. A nonprofit has two: did we deliver on our mission, and did we keep our funding secure by proving we spent money the way donors and grantors said we had to. Because of that second bottom line, nonprofits can't just dump every dollar into one big checking account and call it a day. Instead, fund accounting treats the organization as a collection of separate, self-balancing mini companies, called funds. Each fund tracks its own assets, liabilities, revenue, and expenses, so that a grant earmarked for, say, a playground renovation, never accidentally gets spent on office rent.
Now, before we go further, let's get the vocabulary sorted, because nonprofit financial statements use different names for familiar things and it trips people up constantly. What a business calls the balance sheet, a nonprofit calls the Statement of Financial Position. Same idea, showing what the organization owns versus what it owes, but since there are no shareholders, there's no "equity" or "retained earnings" line. Instead, you get Net Assets. The math is still simple: assets minus liabilities equals net assets.
What a business calls the income statement, a nonprofit calls the Statement of Activities. And instead of sales revenue, you're tracking support or contributions, meaning donations, grants, and pledges.
Then there's a report that businesses don't have to produce at all: the Statement of Functional Expenses. This one's mandated by the Financial Accounting Standards Board, under an update called ASU 2016-14. It requires nonprofits to categorize every expense two different ways at the same time. First, the natural classification, meaning what did you actually spend the cash on: salaries, rent, technology, printing, travel. Second, the functional classification, meaning why did you spend it. That breaks into three buckets. Program Services covers the direct cost of doing the mission, like delivering meals or running a clinic. Management and General covers back office operations, administrative salaries, governance. And Fundraising covers the cost of raising money in the first place: donor software, event planning, grant writing fees. Auditors and donors want to see both views side by side, because it shows how efficiently the organization runs.
Let's talk about net assets in more depth, because this is where a lot of founders get confused. Historically, nonprofits had to track three separate categories: unrestricted, temporarily restricted, and permanently restricted. That same FASB update, ASU 2016-14, simplified this down to just two categories, which made life considerably easier.
The first category is Net Assets Without Donor Restrictions. These are your general-purpose funds, the money you can use however you see fit to run the organization. Here's a nuance that catches people off guard: say your board votes to set aside twenty thousand dollars as a rainy day fund, or savings toward a future building purchase. That money gets labeled "board designated," and it feels restricted in spirit. But under formal accounting rules, it's still classified as without donor restrictions, because the board gave itself that limitation and the board can just as easily vote to undo it. Only restrictions imposed by an outside donor count as true restrictions for reporting purposes.
Which brings us to the second category: Net Assets With Donor Restrictions. This is money that comes with a legally binding condition attached by whoever gave it. Spend it on the wrong thing, and you're not just embarrassed; you're risking legal action and potentially your tax-exempt status. These restrictions come in a few flavors. A purpose restriction says the money can only go toward a specific project, for example, "this money can only be spent on veterinary medicine for the shelter." A time restriction says when the money can be used, like a pledge earmarked for the 2027 fiscal year. And then there are permanent restrictions, also called endowments, where the donor requires that the original gift stay invested forever, and only the interest or investment gains get spent on programs.
Okay, so how does this actually get tracked day to day? This is where a lot of well-meaning founders and volunteer treasurers go wrong. The instinct is often to open a separate bank account for every restricted donation. Don't do that. It becomes chaos fast, especially once you have a dozen small grants running simultaneously. The opposite mistake is relying purely on separate equity accounts to represent each restriction, which also fails, because it breaks your ability to properly categorize expenses by their natural type- salaries versus supplies versus travel- which you need for that Statement of Functional Expenses we talked about.
The practical fix that most bookkeepers use, especially in QuickBooks Online, is Class tracking. You set up a class for each restricted fund, something like "Grant, Playground, 2026." Every time a restricted donation comes in, it gets tagged with that class. Every time an expense gets paid out of that restricted money, the exact same class tag gets applied to that expense. Now you can run a report by class and see, instantly, how much is left in that playground grant and what it's been spent on, all while your regular chart of accounts stays clean for tracking salaries, rent, and so on across the whole organization.
There's one more mechanic worth understanding: releasing funds from restriction. When you actually spend restricted cash on the purpose the donor specified, the restriction lifts, and that has to show up in your books as a specific journal entry. You debit Net Assets with Donor Restrictions, and you credit Net Assets without Donor Restrictions. That transfer lines up with the program expense showing on your Statement of Activities, and it's exactly the kind of paper trail donors and auditors are looking for. It proves, in black and white, that the restriction was honored.
I'll be honest, setting up a functional chart of accounts and a bulletproof class tracking system from scratch is genuinely difficult if you're a new founder or a volunteer board member with a day job. Most people attempt this on a spreadsheet at first, and it usually ends the same way: unreconciled balances, missing documentation, and a scramble right before an audit. This is exactly the gap Archimedes Ledger fills. As a fractional bookkeeping partner working with small businesses and nonprofits, they build custom class tracking frameworks tailored to your specific grants and funds; they handle the month-end journal entries that release restricted funds; they clean up messy historical books; and they produce board-ready Statements of Activities and functional expense reports you can actually hand to your board or an auditor without dread. You can find them at archimedesledger.com. The goal is to take the fear out of fund accounting so your leadership team can spend their energy on the actual mission, not spreadsheet forensics.
Now let's shift to the compliance side, because keeping clean books is only half the job. Every tax-exempt 501(c)(3) organization has to file something with the IRS every year, and which form depends on your financial size. If your organization brings in fifty thousand dollars or less in annual gross receipts, you're in the smallest tier, filing Form 990-N, sometimes called the electronic postcard. It's genuinely minimal: legal name, address, and confirmation that you stayed under that receipts limit.
Step up in size, and if your gross receipts are under two hundred thousand dollars and your total assets are under five hundred thousand dollars, you file Form 990-EZ, a shorter version of the full return. Once you cross either of those thresholds, two hundred thousand in receipts or five hundred thousand in assets, you're required to file the full Form 990. That's a detailed filing, requiring disclosures about executive compensation, governance policies, and the actual outcomes of your programs. It's public information too, so donors and watchdog groups can and do look at it.
Separately from the 990 filings, there's the question of federal grant compliance, governed by something called the Single Audit Act, under Office of Management and Budget Uniform Guidance. If your nonprofit receives and spends federal grant money, directly from a federal agency or passed through a state or local government, you may be required to undergo what's called a Single Audit. Here's genuinely good news on this front: effective for fiscal years starting on or after October first, 2024, the OMB raised the Single Audit threshold from seven hundred fifty thousand dollars to one million dollars. That means mid-sized nonprofits spending under a million dollars in federal grant funds annually are now completely exempt from that audit requirement. That's a meaningful relief, because those specialized audits typically cost between fifteen thousand and forty thousand dollars, money that a lot of small organizations would rather put toward programming.
The same Uniform Guidance update included a couple of other helpful changes. The de minimis rate for recovering indirect costs, meaning the administrative overhead a nonprofit can claim on federal grants without negotiating a custom rate, went up from ten percent to fifteen percent of modified total direct costs. And the threshold for when you have to capitalize equipment as a long-term asset rather than just expensing it went up from five thousand dollars to ten thousand dollars. Both changes reduce paperwork burden for smaller organizations.
There's also a tax you need to know about called UBIT, short for Unrelated Business Income Tax. Nonprofits are allowed to earn revenue outside of donations, but if that income comes from a trade or business that's regularly carried on and isn't substantially related to your exempt purpose, the IRS wants a cut. Classic examples include selling commercial advertising space in your organization's newsletter, running a public parking lot, or leasing out equipment to outside parties. If your unrelated business income hits one thousand dollars or more in gross receipts, you're required to file Form 990-T and pay corporate income tax on those specific earnings, separate from your normal tax-exempt activities.
And last, don't forget the state-level requirements, because getting your 501(c)(3) status approved by the IRS is really only half of the legal setup. Before you solicit donations, whether online or in person, most states require you to register for charitable solicitation in that state. Skip this step and start fundraising anyway, and you're exposing your organization to state penalties and even class action lawsuits from donors. Most states also require you to renew this registration annually, typically alongside a copy of your federal Form 990, so it's worth putting on the same calendar as your other annual filings.
If you are interested in getting bookkeeping assistance for your non-profit, schedule a time to talk with us today!
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