Most nonprofit financial statements issued before 2018 divided net assets into three categories: unrestricted, temporarily restricted, and permanently restricted. That model is gone. If your organization is still using that language, or your CPA is still presenting statements that way, your reporting does not comply with current accounting standards.
ASU 2016-14 amended ASC 958 and simplified net asset classification to two categories: with donor restrictions and without donor restrictions. The change took effect for fiscal years beginning after December 15, 2017. Every nonprofit producing GAAP-compliant financial statements must follow the two-category model now.
This article explains how the two categories work, how they appear on financial statements, and how to handle the edge cases that cause the most confusion in practice.
Why the Change Happened
The three-category model created confusion because "temporarily restricted" and "permanently restricted" were legal concepts that didn't always align with how assets actually behaved. A pledge with a multi-year spend requirement and an endowment principal were both classified as restricted, but their accounting treatment and long-term behavior were fundamentally different.
ASU 2016-14 replaced functional labels with a simpler question: did a donor impose the restriction, or did the board? Donor-imposed restrictions create net assets with donor restrictions. Everything else is without donor restrictions. The distinction is clear and legally precise.
Net Assets Without Donor Restrictions
Net assets without donor restrictions represent resources the organization can use for any purpose consistent with its mission, without external constraints from donors or grantors.
This category includes:
- Unrestricted operating revenue, including most fee-for-service income, membership dues, and undesignated contributions
- Revenue earned through programs and events
- Board-designated amounts (funds the board has internally earmarked for specific purposes)
- Endowment investment returns available for spending under the organization's spending policy
The board-designated treatment is important. When a board votes to set aside funds for an operating reserve, a capital campaign, or a quasi-endowment, those funds remain legally unrestricted. The board created the designation and the board can undo it. Because there is no donor-imposed restriction, these funds appear in net assets without donor restrictions, with a parenthetical note explaining the designation.
Reporting Net Assets Without Donor Restrictions
The Statement of Financial Position shows the ending balance. The Statement of Activities shows the change during the period. For transparent reporting, most organizations further disaggregate this category on the face of the statements or in the footnotes, distinguishing:
- Undesignated operating funds
- Board-designated amounts (with description of each designation)
- Amounts available for general operations
Disaggregation is not required, but it is best practice and significantly improves usability for board members and major donors who want to understand your true financial flexibility.
Net Assets With Donor Restrictions
Net assets with donor restrictions represent resources subject to stipulations imposed by donors or grantors that limit how, when, or for what purpose the funds can be used.
Two types of restrictions exist:
Purpose restrictions. The donor specifies that funds must be used for a particular program, capital project, or activity. A gift designated "for the after-school tutoring program" carries a purpose restriction. Expenses that meet the restriction criteria release funds from restriction.
Time restrictions. The donor specifies that funds cannot be used until a future date, or that pledges are to be paid in installments over multiple years. A pledge payable over three years carries a time restriction. Restrictions release as the time period arrives.
Many gifts carry both. A multi-year grant restricted to a specific program has both a time component (annual budget periods) and a purpose component (approved program activities). Each restriction must be tracked separately so releases are documented correctly.
Endowment Funds in the Two-Category Model
Endowments require specific attention under the current model. The original gift to a permanent endowment, called the historic dollar value, is permanently donor-restricted. It cannot be spent, only invested. This remains in net assets with donor restrictions indefinitely.
Investment returns on endowment principal are a different matter. Depending on your spending policy and state law, a portion of investment returns may be appropriated for spending. Once appropriated and spent according to any purpose restrictions on the endowment income, those amounts transfer to net assets without donor restrictions.
Underwater endowments are an edge case that caused confusion under the old model. When an endowment fund's fair value falls below the original gift amount due to investment losses, the entire fund, including the underwater portion, is now reported within net assets with donor restrictions. This replaced the prior practice of reporting the deficit in unrestricted net assets. The financial statements must include specific disclosures about underwater endowments: the aggregate fair value, the aggregate historic dollar value, and the aggregate amount of the deficiency.
Conditional Pledges
Conditional pledges add another layer. A pledge is conditional when it carries a barrier the organization must overcome before it is entitled to the funds, not merely a restriction on how funds are used after they arrive. Common barriers include matching requirements, performance conditions, or board approval contingencies.
Conditional pledges are not recognized as assets or revenue until the condition is substantially met. Once met, they convert to unconditional pledges and are recognized as revenue with donor restrictions (if restricted by purpose or time) or without donor restrictions (if unrestricted once the condition is satisfied).
Releases From Restriction
When a purpose restriction is met or a time restriction expires, you record a release from restriction. This entry simultaneously decreases net assets with donor restrictions and increases net assets without donor restrictions. The funds are now available for general use, assuming no other restriction applies.
On the Statement of Activities, releases from restriction appear as a line item in both columns: a reduction in the restricted column and an increase in the unrestricted column. This presentation shows readers that the organization satisfied donor conditions and appropriately deployed restricted resources.
Missing or late releases are one of the most common audit findings at nonprofits. When expenses are incurred against restricted funds but the release entry is not posted, the financial statements show liabilities that no longer exist and understate operating activities. Build the release process into your close cycle, not your year-end cleanup.
What Changed on the Financial Statements
The Statement of Financial Position now shows two net asset lines instead of three. The Statement of Activities now shows revenue, expenses, and changes in two columns instead of three.
The simplification is real, but two new disclosures were added as part of ASU 2016-14:
- Liquidity and availability disclosure. Organizations must now disclose how much of their net assets are available to meet general expenditures within one year of the statement date. This is where the board-designated vs. donor-restricted distinction becomes critical: board designations reduce apparent liquidity even though those funds are legally available if the board changes course.
- Functional expense disclosure. All nonprofits must now present or disclose functional expense allocation. Organizations previously exempt from the Statement of Functional Expenses now need to provide this information at minimum in the footnotes.
Where Manual Systems Break Down
Tracking net asset classification manually creates two problems. First, it requires staff to reclassify transactions at financial statement time rather than at entry time, which means the reclassification depends on someone remembering which gifts had restrictions and which didn't. Second, release-from-restriction entries require a separate calculation each period that is disconnected from the original transaction, making errors easy and hard to catch.
In sherbertOSOS, every transaction is tagged with its fund and restriction status at the point of entry. Restricted revenue flows immediately to net assets with donor restrictions. When expenses are coded to restricted programs, the system calculates and posts the release automatically. The Statement of Financial Position and Statement of Activities reflect the correct classification at all times, without manual reclassification at period close.
Frequently Asked Questions
When did the two-category model take effect?
ASU 2016-14 became effective for fiscal years beginning after December 15, 2017 for most nonprofits. Calendar-year organizations adopted the standard in fiscal year 2018.
Where do board-designated funds appear in the two-category model?
In net assets without donor restrictions. Board designations are internal decisions, not donor-imposed restrictions. The board created the designation and can reverse it at any time, so these funds remain legally unrestricted.
How are underwater endowments classified?
Endowment funds whose fair value has fallen below the original gift amount are reported entirely within net assets with donor restrictions, with required disclosures about the aggregate fair value, historic dollar value, and the amount of the deficiency.
What happens to the old "temporarily restricted" and "permanently restricted" terminology?
That terminology is no longer GAAP. You can use it informally to explain concepts, but financial statements and footnotes must use "with donor restrictions" and "without donor restrictions." Any statements using the old three-category model do not comply with current standards.
How do we handle a gift that is both time-restricted and purpose-restricted?
Track both restrictions separately. The gift remains in net assets with donor restrictions until both conditions are met. If the time condition expires first but the purpose restriction remains, funds are not yet released. Releases require that all applicable restrictions have been satisfied.
The Bottom Line
The two-category model is simpler in structure but more demanding in execution. Knowing which category a gift belongs to is not enough. You need to track the specific restriction, monitor the condition for release, and post the release entry at the right time, every time.
Organizations that run this process manually, through spreadsheet schedules and period-end journal entries, accumulate errors that don't surface until audit. Every unexplained balance in net assets with donor restrictions is a potential audit finding, and every missed release is a misstatement in the operating results.
sherbertOSOS tags every transaction at entry and automates restriction tracking, so your net asset classifications are always current and your releases are always posted when conditions are met.
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Frequently Asked Questions
When did the two-category model take effect?
ASU 2016-14 became effective for fiscal years beginning after December 15, 2017 for most nonprofits.
Where do board-designated funds appear in the two-category model?
In net assets without donor restrictions. Board designations are internal decisions, not donor-imposed restrictions.
How are underwater endowments classified?
Endowment funds whose fair value has fallen below the original gift amount are now reported entirely within net assets with donor restrictions, with appropriate disclosures.
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