Understanding Restricted vs. Unrestricted Funds in Nonprofit Accounting

Cassidy Jakovickas

May 15, 2024

It’s crucial to understand the difference between restricted and unrestricted funds in nonprofit accounting since the usage of these funds impacts the financial reporting and management of an organization. In this blog post, I’ll provide an overview of the key differences between restricted and unrestricted funds, discuss their uses, and offer tips for managing them effectively.

What are Restricted Funds?

Restricted funds are donations or grants specifically designated by donors or grantors for a particular purpose, time period, or location. These funds must be used in accordance with the donor’s or grantor’s restrictions and can’t be used for other purposes.

Common types of restrictions placed on funds include:

  1. Purpose restrictions: The funds must be used for a specific project or program.
  2. Time restrictions: The funds must be spent within a certain time frame or in a specific fiscal year.
  3. Location restrictions: The funds must be used in a specific geographic area or for a specific population.

What are Unrestricted Funds?

Unrestricted funds are donations or grants that do not come with any stipulations or limitations. Nonprofit organizations have more flexibility with unrestricted funds, allowing them to allocate resources as needed to support their mission, operations, and strategic goals.

Comparing Restricted and Unrestricted Funds

Restricted funds are limited in use, while unrestricted funds provide organizations with greater flexibility to meet their needs. Nonprofit organizations must carefully manage and track restricted and unrestricted funds to ensure compliance with donor requirements and accurate financial reporting.

Best Practices for Managing Restricted and Unrestricted Funds

Navigating the financial landscape of a nonprofit organization can be challenging, especially when it comes to managing restricted and unrestricted funds. Effective financial management is essential not only for maintaining the organization’s credibility but also for ensuring its long-term sustainability.

  1. Maintain accurate and organized records: Keeping separate records for restricted and unrestricted funds is crucial for proper tracking and reporting. This practice allows organizations to ensure compliance with donor requirements and maintain accurate financial statements.
  2. Communicate with donors: Regular communication with donors is vital to maintaining transparency and building trust. By providing updates on how their funds are being used, organizations can demonstrate their commitment to donor stewardship.
  3. Create clear financial reporting: Ensuring that financial statements accurately reflect the organization’s restricted and unrestricted fund balances is essential for demonstrating financial accountability and transparency.
  4. Train staff and volunteers: Educating team members on properly managing restricted and unrestricted funds is essential for maintaining compliance and ensuring the organization’s financial health.

Common challenges faced by nonprofit organizations when managing these funds include

Nonprofit organizations often grapple with a variety of obstacles when it comes to managing donor funds. Among the most common challenges are ensuring compliance with donor restrictions, accurately allocating expenses between different funds, and maintaining effective communication with donors about how their contributions are being utilized. 

Ensuring compliance with donor restrictions

Noncompliance can lead to a loss of trust, potential legal issues, and negative impacts on the organization’s reputation. It’s vital that nonprofit organizations develop a system to track and monitor donor restrictions and regularly review donor agreements and grant contracts to ensure a clear understanding of the restrictions. It’s also beneficial to implement internal controls and conduct periodic audits to ensure compliance with donor requirements.

Properly allocating expenses between restricted and unrestricted funds

Improper allocation can lead to inaccurate financial reporting and potential noncompliance with donor requirements. Allocating expenses can be a complex task, especially when expenses relate to multiple projects or programs. To aid your grant and fund allocations, develop guidelines and procedures for expense allocation and implement fund accounting software. It’s also important to train finance and program staff to ensure allocation processes are consistently followed, and regularly review expense allocations to identify errors or discrepancies.

Communicating effectively with donors about fund usage

Maintaining open and transparent communication with donors about how their funds are being used is essential for building trust and fostering long-term relationships. However, organizations often struggle with finding the right balance between sharing too much information and not enough. To aid your donor communications, consider these tips:

  • Develop a communication strategy that outlines the frequency, methods, and content for donor updates.
  • Tailor communications to individual donor preferences, when possible, to ensure they receive information that is relevant and meaningful to them.
  • Use a variety of communication channels, such as newsletters, social media, and in-person meetings, to engage donors and share information about fund usage.
  • Be transparent and honest about challenges, setbacks, and successes in using donor funds, demonstrating a commitment to accountability and continuous improvement.

Understanding and properly managing restricted and unrestricted funds is essential for nonprofit organizations to ensure financial stability and compliance with donor requirements. By implementing best practices for managing these funds, your nonprofit organization can maintain transparency, build trust with donors, and better allocate resources to achieve its mission.