Restricted vs. unrestricted funds: what donor restrictions mean, and the mistake small nonprofits make most

Two classes, not three

Accounting Standards Update 2016-14, issued by the Financial Accounting Standards Board in August 2016 and effective for fiscal years beginning after December 15, 2017, replaced the old three-class model. The former unrestricted, temporarily restricted, and permanently restricted categories are gone.

What remains is a simpler pair:

• Net assets with donor restrictions. Amounts subject to a donor-imposed stipulation on purpose, on timing, or on perpetuity.
• Net assets without donor restrictions. Everything else, including anything the board has set aside on its own authority.

The change was not cosmetic. Collapsing temporary and permanent restrictions into one line moved the detail into the notes, where organizations now have to describe the nature and amounts of the restrictions rather than let a balance-sheet caption do the work.

What creates a restriction

A restriction comes from outside the organization. It is created by the donor, the grantor, or the terms of the gift instrument, and only they can release it.

Three familiar forms:

Purpose restrictions. A gift given for a stated use. Funding the after-school program, not general operations.

Time restrictions. A gift that cannot be spent until a period arrives. A pledge payable next year carries an implied time restriction.

Perpetual restrictions. An endowment gift, where the corpus is to be held in perpetuity and only the return is available for use.

Restrictions end when the stipulated time elapses or the stated purpose is fulfilled. At that point the amount is reclassified out of net assets with donor restrictions and into net assets without them. The statement of activities shows the movement between the two classes.

The board-designation trap

This is the distinction that causes the most trouble, because the language sounds identical in a board meeting.

A board can vote to set aside $40,000 as an operating reserve. That is prudent governance. It is not a donor restriction. The money stays in net assets without donor restrictions, because the board that imposed the designation can reverse it at any time by another vote.

ASU 2016-14 does require disclosure. An organization must disclose the amounts and purposes of board designations of net assets without donor restrictions. So the reserve is visible — it is simply visible in the notes rather than reclassified on the face of the statement.

The same update added a liquidity and availability disclosure: a description of how the organization manages liquid resources, and the quantitative amount of financial assets available to meet cash needs for general expenditure within one year of the balance sheet date. Restricted balances and board designations both reduce that figure. This disclosure is the one most likely to surprise a board seeing its own financials for the first time under the current standard.

Where it shows up on Form 990

That last row deserves emphasis. Form 990-EZ does not ask for the split. An organization filing the EZ can go years without ever having to state its restricted balance on a return, which makes it easy to conclude the tracking does not matter. It matters the moment the organization grows into the full Form 990, applies for a grant that asks for audited or reviewed statements, or triggers California’s audit threshold.

California’s layer

California adds requirements that sit on top of the accounting standards.

UPMIFA. California adopted the Uniform Prudent Management of Institutional Funds Act at Probate Code section 18501 and following, effective January 1, 2009. It governs how institutional funds — endowments in particular — are invested and spent. California is among the states that adopted the optional rebuttable presumption in section 18504(d): an appropriation for expenditure in any year of more than 7 percent of the fair market value of an endowment fund, calculated on at least a three-year rolling average, creates a rebuttable presumption of imprudence. It is a presumption, not a hard cap, but a board spending above that level should expect to have to justify it.

Charitable dedication. The Attorney General’s Guide for Charities describes the assets of a California charity as irrevocably dedicated to charitable purposes. Restricted funds sit inside that framework, and diverting a restricted gift to another use is a matter the Registry of Charities and Fundraisers treats seriously.

The $2 million audit threshold. Under Government Code section 12586(e), a charity with gross revenue of $2 million or more in a fiscal year, excluding grants from and contracts for services with government entities, must have financial statements prepared under generally accepted accounting principles and audited by an independent certified public accountant, available within nine months of fiscal year end, and must have an audit committee. Organizations approaching that line should have clean net asset classification well before they cross it, not during the first audit.

Federal awards. Organizations receiving federal money are subject to 2 CFR part 200. Section 200.302(b)(3) requires records that identify the source and application of funds for federally funded activities. And the Single Audit threshold is now $1,000,000 in federal awards expended in a fiscal year under 2 CFR section 200.501(a), raised from $750,000 by the revisions published at 89 FR 30136 on April 22, 2024 and effective October 1, 2024.

The mistake, stated plainly

One checking account. Money arriving from several sources, some of it restricted. Expenses paid out of the same balance without reference to which pool funded them.

Nothing looks wrong for a while. The failure appears at a specific moment: the organization has $30,000 in the bank and $22,000 of it is restricted to a program that has not run yet. Payroll needs $18,000. The available balance was never $30,000.

Two consequences follow. Operationally, the organization spends money it did not have the right to spend. Reportorially, the release from restriction was never recorded, so the statements show restricted balances that no longer exist and unrestricted balances that were never there.

This surfaces most reliably during an audit or a grant review, because both include a test of whether restricted funds were used as intended. By then the correction is a restatement rather than an adjustment.

What tracking actually requires

Not separate bank accounts. Commingling cash is permitted; what is required is that the accounting records identify the restrictions and the releases. Separate accounts can help discipline, but they are an operational choice, not an accounting requirement.

What is required is a system that answers four questions on any given day: how much of the balance carries a donor restriction, what each restriction is for, how much has been released and why, and how much is genuinely available for general use.

In practice, for a small California nonprofit, that comes down to a few habits:

• Read and file the gift instrument. The award letter, the grant agreement, the note on the check. If it states a purpose, that is a restriction and it needs to be recorded as one at the time of the gift, not at year end.
• Record the release when the purpose is fulfilled, in the same period the expense hits.
• Keep board designations documented in the minutes, and keep them out of the restricted class.
• Produce a statement of financial position that shows both classes, monthly, and put the available-for-general-use figure in front of the board every time.

In QuickBooks Online, most organizations achieve this using class tracking for restrictions and location tracking or projects for grants and programs. That is practice guidance, not a rule from any standard or statute — the standards specify what must be reported, not which software feature produces it.

The four annual filings that sit alongside all of this are covered in our piece on California’s nonprofit annual filings.

Common questions

What is the difference between restricted and unrestricted funds?

Net assets with donor restrictions are subject to a stipulation imposed by the donor or grantor on purpose, timing, or perpetuity. Net assets without donor restrictions are everything else. Only the donor can impose or release a donor restriction.

Is a board-designated reserve a restricted fund?

No. A board designation is made by the organization and can be reversed by the organization, so the amount remains in net assets without donor restrictions. Under ASU 2016-14 the amounts and purposes of board designations must be disclosed.

Do we need a separate bank account for restricted funds?

No. Restricted and unrestricted cash may be held in the same account. What is required is that the accounting records identify the restrictions, the releases, and the amount available for general use.

Where do restricted funds appear on Form 990?

On Part X, line 27 for net assets without donor restrictions and line 28 for net assets with donor restrictions. Endowment funds are reported on Schedule D, Part V. Form 990-EZ reports a single combined net assets figure with no split.

What is the 7 percent rule for California endowments?

California Probate Code section 18504(d) creates a rebuttable presumption of imprudence when an organization appropriates more than 7 percent of an endowment fund's fair market value in a year, calculated on at least a three-year rolling average. It is a presumption that can be rebutted, not an absolute limit.

When does a California nonprofit need an audit?

Under Government Code section 12586(e), gross revenue of $2 million or more in a fiscal year, excluding government grants and contracts for services, requires financial statements audited by an independent certified public accountant, plus an audit committee.