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Endowment accounting is the process of tracking, categorizing and recording financial transactions that involve a nonprofit organization's donor-restricted investment funds. It typically uses the same standards and processes as ordinary financial accounting but applies it to assets that have specific restrictions that affect how they are handled and carried on the books. The most important task in endowment accounting is making sure that funds that are restricted by the donor continue to be used according to the donor's expressed wishes, no matter how much time has passed since the donation was made.
Certain types of nonprofit organizations accept donations that the donor restricts for a specific purpose. Most jurisdictions that recognize the special status of nonprofit organizations also legally allow donors to specify how a gift to the organization should be used. If a nonprofit violates the agreement to use a donation in a specific way, the donor can demand the return of the gift.
Colleges, universities, cultural institutions and religious organizations place certain donor-restricted gifts into an account called an endowment fund. Common types of endowment funds are scholarship funds, academic chairs, building funds and general investment funds. Some endowments allow the institution to use the principal in a certain way until the fund is exhausted, such as a scholarship fund. Other types of endowment funds do not allow the institution to spend the principal. Instead, the institution is allowed to invest the donations and use the interest for operating expenses or any other permissible purpose.
The fact that every donation can come with a restriction that the institution must track means that endowment accounting has to incorporate special procedures to ensure that the funds are used properly. Generally-recognized accounting standards require institutions to separate endowment funds into permanently restricted assets and temporarily restricted assets. Permanently restricted assets are gifts that do not allow the principal to be spent. Temporarily restricted assets either have a time limit on the restriction or allow the institution to use up the principal at some point.
Another particularity of endowment accounting comes from the fact that many nonprofits are exempt from government taxes. The process of tracking endowment assets in an accounting system must substantiate the use of the assets and income for purposes that are allowed by the jurisdiction's tax code. Improper use of endowment funds can jeopardize an institution's nonprofit status, while failing to properly manage an endowment accounting system can result in legal and tax liability.