Why clear reporting, and clear rules, are the key to keeping donor trust.
Managing restricted funds is one of the most challenging accounting tasks nonprofit organizations face, even those with strong financial practices.
We’ve seen it happen: A donor restriction overlooked in a spreadsheet can trigger a last-minute scramble at year-end, resulting in audit adjustments when balances don’t reconcile with donor records. As a result, staff find themselves digging through records, reclassifying expenses, and hoping the numbers finally align.
Even nonprofits with the best intentions run into trouble when restrictions are not tracked closely. Leaders may mistakenly think restricted funds are available for everyday operational expenses, only to learn later that donor designations actually restrict how they can be spent. In one case, a nonprofit tapped endowment income for operations, which led to audit adjustments and tough board conversations.
Mismanaging restricted funds doesn’t just create reporting issues — it exposes organizations to legal, ethical, and reputational risks. The good news? With the right processes, these stressful situations are entirely preventable.
What Are Restricted Funds, Really?
Restricted funds are contributions from donors that come with strings attached – meaning the donor specifies how and/or when the money can be used. Unlike unrestricted funds—which can be used for any purpose, at any time—restricted funds must be spent according to the donor’s intent. Honoring that intent isn’t just good stewardship; it’s a legal and ethical obligation. A donor’s designation for a restricted gift can be detailed at the time of the donation or pledge through various means such as a gift agreement, pledge form, donation letter, check stub or even verbally.
There are two main types of restrictions:
- Temporarily restricted funds – designated for a specific purpose or time period. Example: a grant to fund a summer youth program in 2026.
- Permanently restricted funds – principal balance intended to be maintained in perpetuity, such as endowments. The organization can typically use the earnings, but not the principal.
For audit purposes, these are combined into one category called “with donor restrictions.” However, for internal tracking and decision-making, it’s often more useful to track them separately as temporary and permanent.
Donor restrictions typically fall into two categories:
- Time-based – the funds can only be used after or during a specified period, or they are attached to a multi-year pledge agreement and will be received at some point in the future.
- Purpose-based – the funds must be used for a specific program, project, or expense (e.g., scholarships, capital campaigns, or disaster relief).
Sometimes, both apply.
In other words, how and when you use the funds matters just as much as where they came from.
Pro Tip: When in doubt, document. Even if a donor’s restriction is made verbally, follow up in writing to confirm intent. This creates a paper trail that protects both you and the donor relationship. This addresses a common gray area nonprofits face.
The Hidden Risk of Poor Tracking
When restricted funds aren’t tracked properly, it’s all too easy to make a costly mistake—like spending restricted funds on unrestricted expenses. This happens more often than most nonprofits realize.
The consequences can be serious:
Damaged donor trust
- Donors give with a purpose. If they learn that their gift wasn’t used as they intended—say, a scholarship gift that ended up covering payroll—they’re far less likely to give again. It isn’t just that one supporter either, improper allocation can lead to a damaged reputation within your community.
Financial audit red flags
- Poor tracking often comes to light during an audit and may lead to reclassifications, management letter comments, repeat findings, or in severe cases, a modified audit opinion if restricted net assets are materially misstated. Any of these outcomes can erode credibility with grantors, foundations, or major donors who rely on audits to evaluate your financial health.
Potential legal consequences
- If the IRS discovers misuse, your organization could face penalties such as fines or even the loss of your tax-exempt status. Your organization could face lawsuits as donors and funders reserve the right to sue for misallocated funds. Donor restrictions on gifts are legally enforceable. Keep restricted fund documentation (gift agreements, grant letters) in a central digital file accessible to both development and finance. Fragmented storage is one of the top reasons restrictions are overlooked.
Inaccurate picture of financial health
- Internally, poor tracking can give the impression that the organization has more cash on hand than it does, leading to skewed budgets and misreported revenue. Without clear financial reporting and tracking, restricted funds might be misused for operational expenses, your board may lack a clear understanding of the organization’s financial position, and fixing these errors can be both costly for the organization and painful for staff.
Revenue recognition adds another layer of complexity. Some contribution agreements include language that classify them as “conditional.” Conditional contributions are classified as liabilities until the specified conditions are met. Most contributions, however, are recognized as revenue when received. Reimbursement grants are recognized only when funds are spent, and exchange grants are recognized in accordance with for-profit revenue recognition standards. Incorrect recognition can distort financial statements, create compliance issues, and leave you asking, “Why is there revenue but no cash?” Auditors will test whether your recognition aligns with GAAP. If it doesn’t, they may propose audit adjustments that delay finalizing and releasing your audited financial statements
At Chazin, we’ve seen firsthand how quickly these issues escalate when the numbers don’t align.
Why This is So Common
Inaccurate tracking isn’t usually a sign of incompetence—it’s a sign of how complex restricted fund accounting can be. Common causes include:
- Lack of understanding of restricted contributions
- Lack of understanding of the nuances involved in recognizing revenue
- Relying on disconnected spreadsheets
- Outdated or incomplete accounting software data
- Lack of dedicated accounting software
- High staff turnover
- Communication breakdowns between departments
These challenges are common—but they do require intentional action to fix.
How to Get it Right
Getting restricted fund accounting right starts with the right systems and habits:
- Use accounting software that allows you to track funds on multiple dimensions—not just a spreadsheet or general ledger. Well-documented reports not only keep management informed but also serve as audit-ready schedules, saving time during fieldwork.
- Reconcile monthly to catch and resolve issues before they snowball.
- Foster collaboration between development and finance so donor restrictions are clearly documented, communicated, and honored. Auditors routinely test whether donor restrictions are clearly documented and traceable from the donor agreement to the general ledger. Collaboration ensures that trail is intact.
Beyond Compliance
Earlier, we noted how poor tracking can damage donor trust. But the reverse is also true: When restricted funds are well-managed, they become a powerful trust-building tool. Compliance is the must-do side of restricted funds, but there are mission-driven and relational reasons for proper tracking and use of these funds that should be just as important.
Donors often give with a specific vision in mind. By honoring the restrictions placed on their gifts, you show that your organization values their support seriously and that you want donors to see their impact carried out. By using funds properly, you build a trustworthy reputation with your community and supporters.
The foundation you build with your donors and funders can open the door to future pledges, planned gifts, or long-term commitments. Even small instances of mismanagement can weaken confidence and sabotage these opportunities. Conversely, consistently honoring donor intent can be a powerful part of your fundraising story — sharing examples of how restricted gifts were stewarded well demonstrates accountability and inspires future giving. Careful stewardship turns compliance into an opportunity.
Practical Tools and Best Practices
- Implement and use an accounting system designed for nonprofits. Platforms like Quickbooks, Martus, and Sage Intacct allow you to separate restricted and unrestricted funds, create fund codes, and generate reports that align with donor requirements.
- Create and use clear coding structures to record gifts. Assign program, project, or restriction codes from the start to avoid later confusion and ensure that expenses are linked to their correct funding source.
- Document donor intent at the time of the gift by saving copies of the donor’s designation and/or restrictions. Enter these details into your system so that details are not forgotten or “lost in translation.”
- Review and reconcile restricted balances regularly. Don’t wait until the year-end; ensure that spending is being properly tracked monthly or quarterly. Don’t just reconcile balances — reconcile donor intent. Compare the restrictions logged in your accounting system with original donor documents to confirm alignment.
- Build internal review processes that employ a second set of eyes. Small organizations with limited staff can still achieve this by engaging a finance committee member or volunteer accountant for periodic reviews. Restrictions and allocations aren’t only important to finance teams; include other departments and staff to help catch misuse before it happens. With the right tools, clear processes, and consistent communication, your organization can ensure every dollar is used as intended. More important, strong practices around restricted funds strengthen trust with donors, support long-term sustainability, and give your team the clarity it needs to focus on advancing your mission.
The Bottom Line
At Chazin, we help nonprofits track their restricted funds accurately, identify potential issues early, and stay audit-ready year-round. Mismanagement of funds can be corrected, and starting now is far better than waiting until a crisis hits. If your auditor has raised concerns about restricted funds, or if you want to avoid repeat findings, we can help you strengthen processes now so your next audit runs smoothly.
Your donors trust you to honor their intent. The right processes will ensure you can keep that promise.
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Chazin
With over 20 years working exclusively with nonprofits, we pride ourselves in having a unique understanding of nonprofit accounting needs. We believe that nonprofits deserve personalized, quality service and should not settle for a one-size-fits-all approach. We collaborate with you to provide a fully virtual and customized solution that is not only cost-effective but also strengthens your accounting function. We offer a team of industry experts at your disposal to provide advice, leading technology, and to supplement existing staff to improve efficiency and compliance.