I’ve served as treasurer for three separate organizations over the last six years. Two of them are US 501(c)(3) non-profit organizations. The other is a consumer-owned cooperative. I’m not an accountant, but I’ve learned a lot about accounting, and each organization has forced me to learn something new.
Today’s adventure is learning how to deal with restricted funds, or funds that have to be used for a particular purpose. I’m going to show four different techniques for dealing with restricted funds, along with some pros and cons.
Restricted funds are conceptually similar to earmarked funds and fiscal sponsorships. In all cases, you have a specific amount of money that is supposed to be used for a specific purpose. I’ll make the following distinction: Both restricted funds and earmarked funds are short-term situations where you expect to spend the money, zero the balance, and stop looking at it. When I talk about restricted funds, I mean funds where you are legally obligated to spend and account for every penny, and pay back any money you did not spend. This could be a grant where the granting organization places requirements on the funds. When I talk about earmarked funds, I mean funds that you have designated for a particular purpose, but where you’re not legally obligated to spend it all, and you could roll a small leftover balance into general funds. This could be money from a targeted fundraising campaign.
Fiscal sponsorships, however, are long-term arrangements where you handle the money for a group of people doing something in line with your charitable cause. They officially operate under your organization so they don’t have to deal with all the non-profit paperwork, but they have a certain amount of autonomy, and importantly, their funds are theirs.
I’ll use the term targeted funds to refer to all three. The following techniques all conceivably work for each type of targeted funds, with different pros and cons on each. None of these techniques are, in my opinion, perfect. Also, by the way, I have to assume you have a passing familiarity with double-entry accounting and split transactions, among other things. Explaining those is another blog post. Onward…
With this technique, you create a subaccount of your primary asset account (probably a checking account), and post all transactions for the targeted funds to that account. This has the advantage of letting you use expense and income accounts however you want, and it might be OK if you have very small and very simple transactions.
I don’t like this technique, though, for a number of reasons. It can lead to really crazy split transactions. Split transactions where money comes from separate income accounts are fine. Split transactions where money goes to multiple asset accounts are weird. Split transactions where both happen hurt my brain.
This really falls apart when you have multiple very liquid asset accounts. By that I mean accounts you regularly make payments from. This could be a checking account, a PayPal account with money in it, a prepaid postage account for bulk mailings, or a prepaid purchase card at a store. (I’ve dealt with all of these.) Or you might have liability accounts you regularly expense from, like a credit card or an expense account at a store.
If your targeted funds are a subaccount of your primary checking, what happens when you use another account to pay with those funds? If you used a credit card, you probably need to use a split transaction when you make your monthly payment. I hope you remember how much. You’d better look through your transaction report. I don’t even know what to do if you carry a balance on the card. And if you paid with PayPal or another asset account, you should really transfer money from checking to cover it, and record that as coming out of the subaccount. What a pain. The easier approach is probably just to use a journal entry to move money from the targeted subaccount to its parent. But that basically means your books will be littered with fake adjustment entries.
Also, there’s a big question mark around how well your accounting tools deals with transactions in a subaccount of a checking account when doing things like reconciliation or automatic transaction importing. My advice is that asset accounts on your books should match real accounts. This technique is just a hack.
Actual Separate Account
If accounts in your books should always match real accounts, why not create an actual separate checking account for the targeted funds? This technique involves quite a bit of overhead, and it’s not something you’re going to do for short-term restricted or earmarked funds. But it could work for fiscal sponsors, with the added benefit that you could even allow your sponsored organization access to that account.
This at least ensures that accounts are accounts and transactions are transactions, but it can still be tricky if you want to spend those targeted funds with other payment methods like a prepaid account or a credit card. If you do that, you’ll have to write an actual check (or make an actual bank transfer) to pay one part of your organization from another part. That’s a hassle, although it is sensible.
There’s also an issue of minimum balances. Your bank may insist on a minimum balance on all checking accounts. You probably don’t care about a minimum balance for your sponsored organizations. You might even be OK with them holding a zero balance. (In the case of restricted or earmarked funds, a zero balance is your goal.) You just might be OK with allowing sponsored funds to be temporarily negative. Banks don’t care for that, so you would have to spend money from your general account, and then record the money owed in some sort of weird entry that is both accounts payable and accounts receivable.
This is probably the technique your accountant will recommend, especially for legally restricted funds like restricted donations. A liability account is a type of account you use to record money you owe. You can make purchases with a liability account. You can pay into it to pay it off. A credit card, for example, is a liability account. A credit card purchase is a transaction involving a liability account and (usually) an expense account. A payment toward your credit card balance is a transaction involving a liability account and an asset account. Liability accounts can be other types of debts, or other types of money you have to spend, like taxes payable.
Money you have to spend. Like that big grant that has to be spent for a specific purpose. It’s strange to think about a grant as a liability, but from an accounting perspective, it fits.
This has the advantage of quickly showing you how much you need to spend and how much money you have in general funds, right on the balance sheet. No other technique makes those numbers quite as clear. The downside is that it’s a black box on an activity statement. You don’t get to use expense and income accounts for anything, and if you want to get any sense of how much you’ve actually spent, or how you’ve spent it, you have to dig into transaction reports. That’s doable, but I don’t enjoy it.
One other thing to consider with this technique is what to do with a not-quite-zero balance. If you overspend, you’ll need to do a split transaction with part of it coming from a general expense account. Otherwise you’ll spend the rest of your life with a weird negative liability on your balance sheet. And if it’s earmarked funds where you can roll a small remaining balance into general funds, make sure to post a transaction that moves that money from the liability account to an income account
If you deal with a very large number of restricted grants, and you need to be absolutely certain they all get spent entirely and in a timely fashion, you should strongly consider this approach. You should also talk to an actual accountant, preferably one with non-profit experience, instead of reading a blog by some guy on the internet.
Income and Expense Accounts
Finally, you can just create specific income and expense accounts to track money into and out of targeted funds, respectively. You can do this alongside the first two techniques involving separate asset accounts, but one of the advantages of those techniques is that you don’t absolutely have to use targeted income and expense accounts. With those techniques, you could record payments to a contractor in your general “Contractor Payments” expense account, if you want.
With this technique, you have to make absolutely certain that every transaction involving the targeted funds is posted to a targeted income or expense account. If you don’t, you will never be able to find the targeted fund balance, you’ll start treating that money as general funds, and some people will be very very upset with you. But frankly, with any technique, you need to be careful to file things correctly.
The biggest downside of this technique is that it tells you nothing on your balance sheet. Your balance sheet won’t tell you how much targeted funds you’ve spent, how much you still need to spend, or how much general funds you actually have after accounting for targeted funds. For some people, that will be a really big deal. If restricted grants or fiscal sponsorships constitute a very large portion of your finances, you probably want to see them on the balance sheet. If you handle targeted funds only rarely, and your general funds are comparatively large, it’s less of an issue.
The really nice thing about this technique is that you still get to see income and expenses in actual income and expense accounts. It shows up in your activity statement. It can show up in your budget report, if you want to budget it. You aren’t even limited to using a single account for expenses. You could have a parent expense account for the specific targeted fund, then subaccounts for things like contractor pay, material costs, etc.
Since this technique doesn’t show you anything on a balance sheet, you’ll need to use an activity statement to see the balance of any targeted funds. Grab an activity statement covering at least the entire period of time the targeted funds have been active (or just for all time), then subtract the targeted expense account from the targeted income account to see how much you have left to spend. Or much more simply, most accounting software lets you run an activity statement on a specific list of accounts. Run one on just your targeted accounts, and it will tell you the balance right at the bottom.
This might seem awkward, but it’s actually no different from what you probably do for non-targeted funds with matched income and expense accounts. For example, if you run a large event, you probably have one or more income categories specifically for that event, and one or more expense categories specifically for that event. If you want to see if the event made or lost money, you have to compare numbers in an activity statement, just like you would do to see the balance of targeted funds in this technique.
This technique has no problem with overspending. Just use the same expense categories and don’t bother with splits. You’ll just have higher expenses than income, just like in an event that lost money. It doesn’t show up on your balance sheet, and eventually it will roll off the activity statements you regularly look at. And if you underspend earmarked funds and intend to retain them in general funds, you can just literally do nothing. Just stop looking at the targeted fund activity statement and the money is in general funds. Or, if you want to be really pedantic, post a transaction that moves money from the targeted expense account to an income account like “Retained Earmarked Income”. That way you can go back and see how much earmarked funds you retain over time, if you’re into that.
This technique is actually the one I’ve decided to use for restricted grants in the organization I’m currently treasurer of. Each year, we deal with just a handful of restricted grants, six at the most. We also run exactly one fundraising event where we earmark the funds, and we retain a portion of those earmarked funds into general funds upfront. I have an income account called “Restricted Grants” and an expense account called “Restricted Grant Spending”. For each restricted grant, I create subaccounts of both the income and expense accounts. I can set up custom activity reports for each grant and put them in the pile with other reports that I review monthly. When a restricted grant is spent and accounted for, I just remove it from my regular reports.
Ideally, I’d like a system where I can record transactions as if in income and expense accounts, but somehow group those accounts in a way that makes their difference show up as a liability on the balance sheet. I don’t know if that’s a thing, but it should be.