A Comprehensive Guide to Understanding Restricted Funds for Nonprofit Organizations
- Kimi Witherell
- Dec 10, 2025
- 5 min read
Restricted funds are one of the most important and most misunderstood financial concepts in the nonprofit sector. They influence how organizations plan their programs, manage their budgets, report to donors, and maintain compliance with state and federal regulations. As a professional bookkeeper who works closely with nonprofit leaders, I have seen how a clear understanding of restricted funds can strengthen financial integrity and protect an organization from significant risk.
This article explains restricted funds in extensive detail, outlines the rules that govern them, and provides best practices for managing these funds responsibly.
What Restricted Funds Actually Are
Restricted funds are financial contributions that come with specific donor instructions on how the money can be used. These instructions are legally binding. When a donor designates a purpose, timeframe, project, or program for the contribution, the organization must follow those instructions exactly as written.
Restricted funds can be applied only to the activity defined by the donor. They cannot be moved to other programs, used to cover general operating costs, or redirected to unrelated activities unless the donor gives written consent.
Restricted funds, therefore, represent both an opportunity and a responsibility. They allow organizations to support targeted initiatives, but they also create accountability requirements that must be carefully managed.
The Two Primary Types of Restricted Funds
Restricted funds fall into two main categories. Nonprofit leaders must understand both categories clearly because they are tracked differently and reported differently.
Temporarily Restricted Funds
Temporarily restricted funds are contributions that must be used for a specific purpose or during a specific period of time. Once the stated condition has been met, the restriction is considered satisfied. At that point, the funds are released and can be reported as unrestricted revenue.
Common examples include
Funds are restricted for a specific program, such as an after-school initiative
Grants that must be spent between certain dates
Donations are restricted to equipment purchases
Contributions are restricted to community outreach activities
Once the program is completed or the date requirement is met, the restriction ends.
Permanently Restricted Funds
Permanently restricted funds are contributions that must remain intact forever. These contributions are commonly associated with endowments. The principal amount cannot be spent. Only the investment earnings or distributions generated by the principal can be used. Often, the donor also specifies how those earnings can be used.
For example
A donor may contribute a permanent fund that supports scholarships each year
A foundation may provide an endowment where the principal must remain intact and only the annual interest may be used
These funds create long-term support but require strong financial oversight.
Why Restricted Funds Matter for Nonprofit Financial Health
Restricted funds influence several critical areas of a nonprofit financial system.
They Affect Budgeting
Restricted funds cannot be used to pay rent, payroll, utilities, or administrative costs unless the donor explicitly allows it. Without careful planning, an organization can appear financially healthy because it has cash on the books, yet still struggle to cover operating expenses.
They Affect Cash Flow
Even if restricted funds are sitting in the bank, they cannot be used for unrelated needs. Strong cash flow planning is essential.
They Affect Financial Reporting
Restricted funds must be tracked in separate accounts or classes in the accounting system. They must also be presented separately on financial statements to show the difference between unrestricted, temporarily restricted, and permanently restricted net assets.
They Affect Donor Trust
Donors expect their instructions to be honored. Misuse of restricted funds can damage reputation, reduce future funding, or lead to legal consequences.
How Donor Restrictions Are Created
A donor restriction must be clearly documented. Common sources of restrictions include
Grant agreements
Donor letters
Email instructions from the donor
Foundation contracts
Online donation forms where the donor selects a specific purpose
If the donor states a purpose verbally, it must be documented by the nonprofit to prevent misunderstanding.
If a donor does not provide any instructions, the contribution is considered unrestricted.
Managing Restricted Funds in Your Accounting System
Nonprofit owners must maintain clear and precise accounting practices for restricted funds. Proper management ensures compliance and accurate reporting.
Step One
Create separate accounts, classes, or tracking categories for each restricted fund in your accounting software. This prevents unrelated expenses from being incorrectly assigned.
Step Two
Document the donor restriction in writing and attach it to the accounting record. This serves as evidence during audits and ensures continuity if staff changes occur.
Step Three
Record all expenses related to the restricted fund directly against its assigned category. Never mix restricted and unrestricted expenses.
Step Four
Monitor the remaining balance regularly. Each fund must be tracked individually to determine when the restriction has been satisfied.
Step Five
Release the restriction at the appropriate time by recording a release entry in the accounting system. This transfers the completed funds from restricted to unrestricted net assets.
Common Mistakes Nonprofits Make with Restricted Funds
Several recurring errors place nonprofits at risk. Understanding these mistakes protects your organization from compliance issues.
Using restricted funds to pay for general operating costs
This is one of the most common issues and is prohibited unless donor permission is received in writing.
Failing to track individual restricted funds separately
Combining multiple restricted contributions under a single category creates inaccuracies and prevents proper reporting.
Not reviewing grant agreements carefully
Many grants include detailed rules about spending timelines, reporting schedules, and allowable costs. These must be followed exactly.
Releasing restricted funds too early
Funds can be released only after the donor conditions are fully met.
Not educating staff or board members
Everyone who handles financial decisions should understand the rules surrounding restricted funds.
Best Practices for Strong Internal Control of Restricted Funds
To maintain compliance, transparency, and donor confidence, nonprofit organizations should implement the following practices.
Maintain written documentation of all donor restrictions
Use a detailed chart of accounts that clearly separates restricted and unrestricted activity
Reconcile restricted fund balances monthly
Conduct periodic reviews of each restriction to ensure proper progress
Provide board members with financial statements that clearly show restricted balances
Maintain open communication with donors regarding project progress and fund utilization
These practices protect the organization and strengthen long-term funding relationships.
When Restricted Funds Can Be Modified
In limited circumstances, a restriction may be modified. This can only occur when
The donor provides written approval to change or remove the restriction
The organization petitions the court to modify the restriction under specific state laws, such as the Uniform Prudent Management of Institutional Funds Act
Nonprofits must never assume that restrictions can be changed without proper authorization.
Why Understanding Restricted Funds Strengthens Your Organization
Restricted funds are powerful tools that support meaningful programs and long-term sustainability. They also require rigorous management, disciplined accounting, and clear communication with donors. When nonprofit owners fully understand how restricted funds operate, they can make better financial decisions, create stronger budgets, improve organizational stability, and uphold donor trust.
A nonprofit that handles restricted funds with accuracy and transparency sends a clear message. It is an organization that honors its commitments, values integrity, and protects the investments of its community.
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