How to Account for Restricted Funds: A Guide for Nonprofits

Nonprofit accounting standards require nonprofits to account for funds and donations they receive in specific ways. This includes making accounting provisions for funds with and without donor restrictions.

However, due to the difficulty of complying with these standards, nonprofits are understandably less than eager to manage these funds. And this has led many to seek swift, stress-free ways to account for their restricted funds, including by leveraging fund accounting software.

How exactly are restricted funds meant to be handled, and what are the best methods open for nonprofits to manage these funds? Here's what you need to know.

What are restricted funds?

As the name suggests, restricted funds are gifts or donations that come with specific obligations or instructions regarding their use. The instruction may be that the fund can only be expended in a certain way or must be used for a specific project. The instruction may be to the extent that the fund can only be exhausted in a certain way or that it must be used on a specific project. In either case, when a donor specifies how they want the funds to be used, then the funds are restricted.

Types of restricted funds

Under current accounting standards, these funds are referred to as “funds with donor restrictions.” The restrictions may be temporary or permanent. A temporarily restricted fund may specify that the money be used for a specific purpose within a particular timeframe. After the timeframe is over, the funds become unrestricted.

A permanently restricted fund, on the other hand, is expected to be put to the use specified by the donor in perpetuity. A common example of a permanently restricted fund is an endowment that requires the principal to be perpetually maintained in an investment fund, while the interest is applied to the donor’s instructions.

Restricted vs. unrestricted vs. designated funds

It is important to differentiate among restricted, unrestricted, and board-designated funds. While restricted funds come with usage constraints imposed by the donor, unrestricted funds can be used for any legitimate operational expense. Board-designated funds are unrestricted funds that the board has voluntarily earmarked for a specific purpose.

How should restricted funds be treated?

Nonprofits should track restricted funds separately from other fund assets. While most nonprofits would prefer a tidy balance sheet with a single neat column, they must be prepared to record restricted funds individually in grid-style sheets to properly track and account for the funds.

Each restricted fund is typically treated separately, almost like an independent business. Budgeting will be separate, and so will expensing and other aspects of the accounting process.

All of the income from restricted funds, including multi-year grants, is expected to be recorded on the nonprofit’s books in the year an irrevocable commitment to the funding was received. Even if the funds have not been received yet, the funds must be recorded.

These standards, and more, indicate how much work is involved in dealing properly with restricted funds. But why go through all of this trouble in the first place?

Why is it important to restrict these funds?

The primary, and possibly most important reason, for complying with requirements for restricted funds is trust. Donors usually want to deal with nonprofits that are trustworthy and accountable. When they donate to a specific cause or purpose, they want to be able to see that the nonprofit has followed the instructions properly.

However, even when an organization has carried out a donor’s instructions to the letter, it can be difficult to properly account for the funds without clear, separate financial statements to back them up. As a result, nonprofits that care about showing accountability and trustworthiness will need to ensure the appropriate accounting standards are followed.

Another important reason is to avoid potential liability arising from a breach of donor instructions. In some states, or in relation to certain government-funded donors, this may amount to legal liability, and in relation to private funders, it may cause the nonprofit to become non-compliant with the terms of the fund. The effects of this could range from illegibility to secure reimbursement for expenses, where the grant is reimbursable, to civil fines and penalties for unethical behavior.

Nonprofits with proper accounting procedures can also avoid the danger of co-mingling funds or even misappropriation. They can ensure that there is always an accurate record of what funds are available for what projects. This way, the organization will never run out of cash or find out that it has inadvertently restricted funds that were meant for general operations or vice versa.

Methods of accounting for restricted funds

Primarily, nonprofits manage restricted funds through fund accounting. This includes several accounting best practices from the FASB relating to the handling of donations. Nonprofits adopt several methods to achieve these, including recording donations relating to each restricted fund their:

• Statement of financial position
• Statement of activities
• Statement of cash flow

Most nonprofits also have procedures that they apply to demarcate funds during the budget and assign program codes to each restricted fund. Disbursements, expense records, and other records will then be tied to the specific program code of each fund, making tracking easier.

Many nonprofits use spreadsheets to manage their restricted fund assets. While this can be labor-intensive, it may be useful for smaller nonprofits with only the odd restricted fund donation a year. However, larger nonprofits or those that see a steady stream of funds with donor restrictions may consider leveraging fund accounting software like PreciseGrants.

Where do restricted funds appear on the balance sheet?

Restricted funds appear in the net assets section of your statement of financial position (the nonprofit balance sheet). They are recorded as "net assets with donor restrictions." While they are included in your total net assets, they are not spendable for general operations outside of the restriction.

Sample Statement of Financial Position

Journal entries for restricted funds

Accurate accounting requires precise journal entries to reflect the receipt and release of funds. (Note: Specific account names may vary depending on your chart of accounts or software).

1. Receiving a restricted donation:

• Debit: Cash (Asset)
• Credit: Contribution Revenue - With Donor Restrictions (Revenue)

2. Incurring an expense for the restricted purpose:

• Debit: Expense Account (e.g., Program Supplies)
• Credit: Cash (Asset)

3. Releasing the restricted funds:

• Debit: Net Assets Released from Restriction (With Donor Restrictions)
• Credit: Net Assets Released from Restriction (Without Donor Restrictions)

How to release restricted funds once restrictions are met

Funds are released when the conditions set by the donor are satisfied. This typically happens in two ways:

• Purpose restrictions: The funds are spent on the specific program or project that the donor intended.
• Time restrictions: The stipulated time period has ended.

When releasing funds, it is crucial to remember that a release is a reclassification of net assets, not new revenue. This transfer from restricted to unrestricted funds is documented in the statement of activities, showing a decrease in restricted assets and a corresponding increase in unrestricted assets. Proper documentation must be maintained to demonstrate that the restrictions were met, ensuring donor trust and compliance.

How to set up your chart of accounts for restricted funds

You do not need a separate bank account to hold restricted funds, provided your accounting system tracks them appropriately. A robust chart of accounts should use a classes, funds, or project codes model to segment revenue and expenses. Here’s what this model entails:

• Classes/Project Codes: Assign specific codes to different grants or restricted programs.
• Revenue Subcategories: Create clear revenue items (like government grants vs. foundation grants) to track the source.
• Reporting by Restriction: Ensure your software can generate reports filtering by these project codes to easily view restricted balances versus available operating cash.

Best practices for managing restricted funds

As a general rule, nonprofits should spend restricted funds before using unrestricted funds for a qualifying expense (always confirm specific grant terms first). Follow this checklist for seamless management:

1.  Review the restriction: Understand the donor's exact terms in writing.

2.  Determine conditionality: Check if the gift is conditional or unconditional.

3.  Record correctly: Log the gift in the proper net asset class (with donor restrictions).

4.  Assign a code: Tag the funds with a specific class or project code.

5.  Track expenses: Code all related expenses to the designated project.

6.  Keep documentation: Save receipts and invoices.

7.  Release when met: Reclassify the funds on your statement of activities.

8.  Report balances: Keep leadership informed of available vs. restricted cash during budgeting cycles.

IRS and legal considerations

Donor restrictions are legally and ethically binding. You cannot redirect restricted funds to general operating expenses or other projects without the donor's explicit written consent. Mismanaging these funds can lead to severe legal and IRS consequences. For complex endowments or jurisdiction-specific state law issues, it is highly recommended to consult a CPA or an attorney.

Restricted funds accounting: Frequently asked questions

What are the accounting entries for restricted funds?

When receiving funds, you debit cash and credit contribution revenue (with donor restrictions). When releasing funds, you reclassify them by debiting net assets released from restriction (with donor restrictions) and crediting net assets released from restriction (without donor restrictions).

Where do restricted funds go on a balance sheet?

They are listed in the net assets section of the statement of financial position under "Net assets with donor restrictions."

What is the difference between restricted and designated funds?

Restricted funds are legally constrained by the donor, whereas designated funds are unrestricted funds that a nonprofit's board of directors has voluntarily earmarked for a specific use.

Do restricted funds need a separate bank account?

No, a separate bank account is not required as long as your accounting software uses fund accounting or project codes to track the restricted cash separately.

Can a nonprofit use restricted funds for operating expenses?

No, unless the operating expenses directly fulfill the donor's specific restriction or the funds have been officially released.

What documentation should nonprofits keep surrounding restricted funds?

To avoid issues with ineligibility for reimbursement or audit complications, strict record-keeping is required. Keep the following on file:

• Gift agreements and grant award letters
• Written donor instructions or appeal copy
• Board minutes regarding designated funds
• Budgets and expense reports
• Release support documentation (invoices, timesheets)
• Final grant or reimbursement reports