Final answer:
A custodial fund is used when an entity, like a government or non-profit, holds financial assets for others in a custodial capacity.
Step-by-step explanation:
It is appropriate to account for an activity in a custodial fund when a government or a non-profit organization holds cash or other financial assets in a purely custodial capacity. These funds are held for, and eventually disbursed to, individuals, private organizations, or other governments.
Custodial funds are used when the reporting entity does not have administrative or direct financial involvement with the assets. For instance, an entity might collect taxes on behalf of another government entity or manage transactions related to employee benefit plans without being primarily responsible for the funds.
Other examples include escrow accounts and property taxes collected for school districts by a city.
The key aspect of a custodial fund is that the entity holds the assets but does not have a financial stake in them. Therefore, they do not report these funds as revenues or expenses but instead report custodial activities to reflect fiduciary responsibilities.