Restricted vs. Unrestricted Funds: A Guide for Non-Profits

Of all the challenges non-profit leaders face, from fundraising to program delivery, one of the most critical—and often misunderstood—is the accounting for donations. Making a mistake here doesn’t just create messy books; it can break the trust of your most valued donors and jeopardize your organization’s financial health. The single most common and dangerous error we see is the mishandling of restricted vs. unrestricted funds.

Understanding this core concept is fundamental to non-profit survival. It ensures you honor donor intent, maintain compliance, and present a clear picture of your financial position.

This guide from the experts at Bay Business Group will break down everything you need to know to manage your funds correctly and confidently.

The Two Buckets of Non-Profit Funding

Think of all the money your non-profit receives as going into one of two main buckets: unrestricted or restricted. Where each dollar goes is determined entirely by the donor’s instructions.

Unrestricted Funds: Your Go-To for General Operations

These are the funds your organization has the most flexibility with. When a donor gives a gift with no strings attached, it’s considered unrestricted. You can use this money for anything that supports your mission.

• What they are: Donations, grants, or earned income that can be used for any of the organization’s expenses.

• Common uses:

• • Paying salaries and rent
  • Keeping the lights on (utilities) 💡
  • Investing in new technology or fundraising software
  • Covering day-to-day program expenses

Unrestricted funds are the lifeblood of your non-profit because they cover the essential core costs that grants and restricted gifts often won’t.

Restricted Funds: Donations with a Purpose

Restricted funds are contributions that a donor has designated for a specific purpose, time frame, or project. These stipulations are legally binding. Once a restricted donation is accepted by a nonprofit, the organization has a legal obligation to use the donation as the donor intended. Failing to do so can have serious consequences.

There are two main types of restricted funds:

1. Funds with Donor Restrictions (Formerly “Temporarily Restricted”)

These funds have a restriction that will eventually be met, either by the passage of time or by completing a specific action.

• Real-World Examples:
  • Purpose Restriction: A foundation gives you a $25,000 grant to purchase a new van for meal deliveries. You can only use that $25,000 to buy the van.
  • Time Restriction: A donor pledges $50,000 but stipulates that it is for your next fiscal year’s budget. You cannot spend that money until the new fiscal year begins.
  • Capital Campaign: You receive donations specifically for the construction of a new community center. Those funds are restricted until they are spent on that project.

2. Funds Maintained in Perpetuity (Formerly “Permanently Restricted”)

These are funds where the donor has stipulated that the original gift (the principal) can never be spent. Typically, these gifts are used to create an endowment.

• Real-World Example:
  • An alumnus donates $1 million to a university to establish a scholarship fund. The university can never touch the $1 million principal. However, it can use the investment income generated by that principal each year to award scholarships to students. This ensures the gift continues giving in perpetuity.

How to Manage Restricted Funds: Track, Release, and Report

Properly managing restricted funds is a three-step dance: tracking them correctly from the moment they arrive, releasing them when the restrictions are met, and reporting them accurately to your stakeholders.

Step 1: Track Everything Meticulously

You cannot simply deposit a restricted check into your main bank account and call it a day. You must segregate these funds within your accounting system.

• Best Practice: Use an accounting system like QuickBooks Online or Sage Intacct that allows for “class” or “location” tracking. You can create a separate class for each restricted grant or fund.
• What to Do: When you receive a $10,000 grant restricted for your summer youth program, you record the revenue and assign it to the “Summer Youth Program” class. This allows you to run a report at any time and see exactly how much is in that restricted “bucket.”
• Documentation is Key: Keep a copy of the grant agreement or donor letter that specifies the restriction. This is your proof of the donor’s intent.

Step 2: “Release” Funds as You Spend Them

This is the step where most non-profits get tripped up. You don’t just spend the money out of the restricted bucket. First, you must meet the donor’s condition, and then you “release” the funds from restriction, effectively moving them from the restricted bucket to the unrestricted bucket to cover the expense.

This is done through a journal entry. Let’s walk through an example:

1. The Gift: Your animal shelter receives that $10,000 grant restricted for a “Spay/Neuter Saturday” event. You record it as revenue with donor restrictions.
2. The Expense: You hold the event and spend $8,500 on veterinary supplies and staffing. You pay these bills from your main bank account.
3. The Release: Now that the condition has been met (you held the event), you make a journal entry to release $8,500 from restriction. This entry decreases your “Net Assets with Donor Restrictions” and increases your “Net Assets without Donor Restrictions” by $8,500.

This shows that you satisfied $8,500 of the donor’s intent. The remaining $1,500 stays restricted until you spend it on another spay/neuter event.

Step 3: Report with Clarity and Transparency

Your financial statements must clearly show the difference between your restricted and unrestricted funds. This is crucial for your board, your donors, and your auditors.

• Statement of Financial Position (Balance Sheet): This statement will show your total net assets broken into two categories: Net Assets with Donor Restrictions and Net Assets without Donor Restrictions. This gives a clear snapshot of your organization’s flexibility.
• Statement of Activities (Income Statement): This statement shows your revenue and expenses. It will have separate columns or sections to show revenue coming in with and without restrictions. It will also have a critical line item called “Net Assets Released from Restriction,” which is where you report the funds you moved after meeting donor requirements (like the $8,500 in our example).

Don’t Risk It—Get Expert Help

Managing restricted funds is non-negotiable for sound non-profit governance. Getting it wrong can lead to failed audits, damaged donor relationships, and a reputation that’s hard to repair.

At Bay Business Group, we live and breathe non-profit accounting. We help organizations like yours set up robust tracking systems, manage complex grants, and prepare compliant financial reports that tell a clear and accurate story. If you’re ready to take the guesswork out of your finances and focus on your mission, contact us today for a free consultation.