Accounting is a system of recording financial and business transactions and analyzing the data to make strategic decisions. For-profit organizations use accounting to earn a profit and distribute it to shareholders. Not-for-profit (NFP) organizations use accounting to maintain accountability for their contributions. However, they are not required to distribute their net earnings to the organization’s leaders.
How do Not-For-Profit Organizations do Accounting?
Not-for-profit (NFP) and charitable organizations enjoy special tax status. Donors make contributions in many ways, and NFPs maintain accounts for all types of funds. Four common types of funds NFPs receive are:
- Restricted funds are contributions made by donors for specific purposes. For instance, John contributed to funding medical supplies for orphans. If the NFP does not fulfil the purpose, it returns the funds to John. If it has a balance left after fulfilling the goal, it reinvests the money for the purpose. NFP cannot use the funds to cover additional costs.
- Unrestricted funds are contributions NFP can use for any purpose where there is a need.
- Capital assets are contributions to buy or build assets, like a fund to build children’s playgrounds or buy computers.
- An endowment fund is the capital that generates regular income, and NFP uses this income as a donation.
Charitable contributions are payments in cash or other assets with no expectation of service. Hence, this type of transaction needs a different approach to recognize revenue. Most NFPs use fund accounting to systematically allocate funds and maintain a report of how and when the funds are used.
Types of Fund Accounting
Fund Accounting is an accounting policy NFPs choose for financial reporting. Canadian not-for-profit organizations can choose from two accounting methods – deferral method and restricted fund method – depending on which best reports their fund usage.
Deferral Method of Fund Accounting
In the deferral method, contributions received are reported in the statement of financial positions (the balance sheet of NFPs). But the revenue is recognized in the statement of operations when it is realized. For instance, John contributed $100,000 to buy computers, of which NFP used $65,000 in the current financial year. Therefore, the NFP will recognize $65,000 as revenue and report the remaining $35,000 as deferred contributions under the assets. This is the accounting for restricted funds in the deferral method.
Let’s take another example. Mary donated $60,000 to build a children’s playground in October 2021, but the work started in February 2022. The NFP will not recognize revenue for the 2021 financial year ending December 30, 2021. The entire $60,000 will be reported in assets as deferred contributions. NFP will recognize revenue when the playground work begins. This is the accounting for capital assets in the deferral method.
Restricted Fund Method
The restricted fund method reports the contributions and expenses for each fund separately. Hence, an NFP has an endowment fund, a general fund, and one or more restricted funds in this form of financial reporting.
The restricted fund method recognizes revenue when it is received. NFP deducts that amount as an expense when the fund is used and reports the balance as excess revenue in the statement of operations.
We will take the above example of John. Under the restricted fund method, NFP reports John’s $100,000 contribution as revenue and the $65,000 used contribution as an expense. As a result, the NFP will have $35,000 in excess revenue at the end of the financial year. It will report this excess revenue as cash under the assets category.
Which Fund Accounting Method Should You Choose?
Both deferral and restricted methods have their pros and cons. You have to evaluate your NFP and what type of contributions you receive. Generally, a small NFP that receives infrequent restricted funds might opt for the deferral method.
Contact Glenn Graydon Wright LLP in Oakville for your Accounting Needs.
A professional accountant can help you find ways to save time and costs on your accounting needs. At Glenn Graydon Wright LLP, our small business experts can provide services to support your accounting function, whether you need partial or complete support. To learn more about how Glenn Graydon Wright LLP can provide you with the best accounting expertise, contact us online or by telephone at 905-845-6633.