Restricted vs. Unrestricted Funds: A Complete Guide

Of all the concepts in nonprofit finance, few carry as much legal weight as the distinction between restricted and unrestricted funds. Spending restricted money on the wrong thing is not an accounting error. It is a breach of fiduciary duty, and it can result in legal action, audit findings, loss of donor trust, and in serious cases, loss of tax-exempt status.

Restricted funds carry donor-imposed limitations on how the money can be spent — either by purpose or by time — while unrestricted funds can be used for any organizational purpose, making the distinction between them one of the most important concepts in nonprofit finance.

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The Two Categories Under ASC 958

Under FASB ASC 958 as amended by ASU 2016-14, net assets are classified into two categories:

Net assets without donor restrictions — Resources the organization can use for any purpose. This includes unrestricted donations, earned revenue, program service fees, investment income, and board-designated amounts (which are internally designated but legally unrestricted).

Net assets with donor restrictions — Resources subject to donor-imposed stipulations. These fall into two types:

• Purpose restrictions: The funds must be spent on a specific program, project, or purpose
• Time restrictions: The funds cannot be spent until a future date or event occurs

The former three-category system (unrestricted, temporarily restricted, permanently restricted) was replaced by this two-category model in 2018. If your financial statements or your team still uses the old terminology, the underlying concepts remain the same — but the statement presentation has changed.

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Purpose Restrictions: What They Mean in Practice

A purpose restriction is a legally binding limitation placed on a gift by the donor. It means the money must be spent on the designated purpose and nothing else.

Examples of purpose restrictions:

• "This gift is restricted to the after-school literacy program."
• "These funds are to be used for the capital campaign for the new community center."
• "This grant supports workforce development programming only."
• "This contribution is designated for the scholarship fund."

Purpose restrictions can come from individual donors, foundations, corporations, or government agencies. They are typically established at the time of the gift, through a gift agreement, grant contract, pledge letter, or donor communication.

What constitutes a restriction?

Under GAAP, a donor restriction must be externally imposed (by the donor, not by the organization) and must limit the use of the contributed resource. Vague language — "please use this where needed most" — does not create a legal restriction. Clear, specific language — "for the youth employment program" — does.

How purpose restrictions are released:

A purpose restriction is released when the funds are spent on their designated purpose. Specifically, when an expense is recorded against a restricted fund, the accounting system should record two entries simultaneously: the expense in the operating fund and a release from restriction that moves the equivalent amount from restricted to unrestricted net assets on the Statement of Activities.

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Time Restrictions: Common Forms

A time restriction prevents the use of funds until a specified date or event.

Common time restrictions:

• Multi-year pledges: A donor pledges $25,000 per year for three years. In year one, the entire $75,000 pledge is recorded as revenue — but $50,000 is time-restricted (cannot be spent until years two and three).
• Future program funding: A grant award for a program that starts six months from now. Funds received now are time-restricted until the program period begins.
• Endowment distributions: Some endowment agreements specify that only the annual payout (not principal) is available; the principal is permanently restricted.

Time restrictions release automatically when the specified date or event arrives. This triggers a release-from-restriction entry that moves the funds to unrestricted status.

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Permanent Restrictions: The Endowment Special Case

A permanent restriction requires that the principal be maintained in perpetuity. Only the investment returns (earnings and appreciation) are available for use, and even those may be restricted to a specific purpose.

The most common permanently restricted funds are endowment funds established by donors who want to create a lasting source of support. The organization invests the principal, and the annual payout (typically 4-5% in a spending policy) flows to unrestricted or purpose-restricted use.

Under ASU 2016-14, permanently restricted funds are classified under "with donor restrictions" — the same broad category as temporarily restricted funds, but with disclosures that distinguish the permanent nature of the restriction. Organizations must disclose the amounts subject to perpetual restrictions separately from purpose and time restrictions.

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Board-Designated Funds: Not the Same as Restricted

This is one of the most common points of confusion in nonprofit finance. Board-designated funds are not donor-restricted. They are unrestricted resources that the board has voluntarily earmarked for a specific purpose — operating reserves, future capital projects, a quasi-endowment.

The critical distinction: the board can reverse its own designation at any time by board vote. A donor restriction, by contrast, is a legally binding commitment that the organization cannot override.

Board-designated funds are classified as net assets without donor restrictions on the Statement of Financial Position, even if they are labeled "Board Reserve Fund" or "Capital Fund" internally. They may be shown as a sub-line with a descriptive label, but the parentage is unrestricted.

For a complete treatment of board-designated funds, see Board-Designated Funds: Rules, Reporting, and Best Practices.

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The Legal Consequence of Misusing Restricted Funds

Spending restricted funds on purposes other than their donor-designated use is a serious legal and ethical violation. The consequences can include:

• Donor legal action: Donors have standing to sue for misuse of their gifts in most jurisdictions.
• Attorney general investigation: State attorneys general oversee charitable organizations and can investigate and prosecute misuse of charitable funds.
• Audit findings: Restricted fund misuse appears as a material weakness or qualification in the independent audit, which is a matter of public record for organizations that file audited statements.
• Grant clawback: Government and foundation grantors have audit rights and can require repayment of misused funds.
• Reputational damage: Publicly disclosed misuse of donor funds is one of the most damaging things that can happen to a fundraising organization.

The most common way restricted fund misuse happens is not intentional fraud — it is sloppy tracking. An organization that manages restricted funds in a spreadsheet, or in an accounting system that does not enforce fund restrictions, can unknowingly spend restricted cash on operations when unrestricted cash runs low.

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How to Track Restrictions Correctly

Assign every restricted gift a fund at the point of entry.

Every restricted donation should be posted to a named fund that corresponds to the restriction — not to a generic "restricted revenue" account. A $10,000 gift restricted to the literacy program should go to "Literacy Program Fund," not "Restricted Contributions."

Track fund balances in real time.

You should always be able to answer: what is the unspent balance in each restricted fund? An organization managing 20 restricted grants should have 20 fund balances visible at any time, each reflecting all revenue received minus all expenses charged.

Record release-from-restriction entries when restrictions are met.

Every time a restricted grant pays for a program expense, two entries are required: the expense itself and the release from restriction. Missing the release entry leaves the restricted balance overstated and the unrestricted operating results understated.

Flag restrictions approaching deadlines.

Time-restricted funds that must be spent by a certain date need active monitoring. A grant that expires in 90 days with $40,000 unspent needs attention now, not at year-end.

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The Efficiency Gap: Spreadsheet Fund Tracking

Organizations that track restricted fund balances in a spreadsheet alongside their accounting system create two parallel records of truth that are perpetually out of sync. The accounting system knows what was spent; the spreadsheet tracks what should have been spent against each fund. Reconciling them is a manual exercise that happens, at best, monthly.

The risks: restricted cash commingled with unrestricted operating cash. Release entries missed because the accountant was managing five other month-end tasks. A grant reported as fully spent in the accounting system but with a remaining balance in the spreadsheet — or vice versa.

The Fund Accounting module in sherbertOSOS tracks every restricted gift against its designated fund at the point of entry. Fund balances update in real time as expenses post. Release-from-restriction entries are generated automatically when restricted expenses are recorded. An aging report flags funds with approaching deadlines. There is no spreadsheet overlay — the accounting system is the fund tracking system.

For how restricted and unrestricted net assets appear on the financial statements, see Statement of Financial Position: The Nonprofit Balance Sheet Explained. For the FASB framework governing net asset classification, see Net Asset Classification Under ASC 958: With or Without Donor Restrictions.

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Frequently Asked Questions

What is the difference between donor-restricted and board-designated funds?

Donor-restricted funds carry legally binding limitations imposed by the donor. Board-designated funds are unrestricted resources that the board has voluntarily earmarked for a specific purpose. The board can reverse its own designation at any time. On the Statement of Financial Position, both appear as net assets without donor restrictions — the board designation is disclosed but does not change the classification.

What happens if we spend restricted funds on something else?

Spending restricted funds on unauthorized purposes is a breach of fiduciary duty. It can result in donor legal action, attorney general investigation, audit findings, grant repayment, and reputational damage. It is one of the most serious compliance violations a nonprofit can commit.

How are purpose restrictions released?

When the funds are spent on their designated purpose, a release-from-restriction journal entry moves the funds from net assets with donor restrictions to net assets without donor restrictions. This entry appears on the Statement of Activities as a positive in the unrestricted column and a negative in the restricted column.

What is a permanently restricted fund?

A fund where the donor requires the original principal to be maintained in perpetuity. Only investment returns (earnings and appreciation) are available for use, and those returns may also carry purpose restrictions. Endowment funds are the most common form.

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The Bottom Line

The distinction between restricted and unrestricted funds is not a technical accounting detail — it is the legal framework through which donors hold nonprofits accountable to their stated intentions. Organizations that manage this distinction well — with real-time fund balance tracking, automatic release entries, and proactive deadline monitoring — maintain donor trust and avoid compliance risk. Organizations that manage it poorly, however carefully their intentions, face meaningful legal and reputational exposure.

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