Restricted funds are donations set aside for a specific purpose or timeframe designated by the donor. By adhering to these restrictions, your nonprofit will respect donors’ wishes. This is critical because financial mismanagement can lead to repercussions such as fines, penalties, or loss of tax-exempt status, plus the potential reputational damage incurred.
In this guide, we’ll cover the best practices every nonprofit should implement to manage restricted funds properly.
1. Establish Clear Documentation and Tracking
Just as your nonprofit meticulously records noncash gifts, grants, and other donation types, you must also track restrictions. Doing so helps you keep a close eye on restricted funds and ensure they’re used for their intended purposes.
Note restricted funds in your:
- Statement of Activities: This financial statement categorizes your revenues and expenses and divides them into restricted and unrestricted. Distinguishing funds this way allows you to track restricted expenses against restricted revenue.
- Statement of Financial Position: This report reflects your organization’s assets, liabilities, and net assets. The net assets are broken down between those with donor restrictions and those without, and represent total restricted funds not spent regardless of the year they were received.
- Your nonprofit’s budget: Your budget should reflect donor-restricted funds to ensure you properly allocate them. Restricted funds should always be spent first as long as they are spent for the donor’s intended purpose.
Professional nonprofit accountants play a pivotal role in properly documenting restricted funds. Enlisting an expert’s help ensures you allocate all resources effectively—not just restricted funds. Plus, a professional with nonprofit experience will know how to maintain compliance with your recordkeeping practices and tax forms.
2. Segregate Funds To Avoid Misuse
Donor restrictions dictate how funds can be spent, but how can your nonprofit ensure they’re actually sorted according to those wishes? Standard accounting practices offer a safeguard by separating restricted funds in your accounting records from general funds to protect donor-imposed conditions when using them.
According to Chazin & Company’s nonprofit accounting guide, “most nonprofits use a method called fund accounting, which involves allocating resources into separate funds according to their intended purposes.” Under this system, nonprofits classify funds according to their source, purpose, and one of two net asset categories:
- Unrestricted funds, which may include board-designated funds
- Restricted funds
Additionally, consider establishing dedicated accounts to segregate funds, where you deposit high-level restricted funds into their own bank account. This approach is especially beneficial for high-priority grants or large projects, where precise expense tracking is essential for compliance. Dedicated accounts also provide a clearer picture of available funds, showing you where unrestricted funds should be allocated to make up shortfalls.
3. Communicate With Donors
Whether restricted or unrestricted, your nonprofit should always be upfront about how it uses donors’ contributions. Transparency is the key to securing donor trust and helps your nonprofit manage restricted funds more effectively.
Help donors understand the implications of restricted funds by:
- Highlighting your mission: Donations don’t need a specific designation to further your mission. For example, unrestricted funds may cover rent, utilities, employee salaries, and other administrative costs that indirectly (but critically) support your work. Market your mission when soliciting donations, reminding donors that their gift still supports the causes they care about without donating to a specific program.
- Fundraising for specific programs: When soliciting donations for a specific purpose, highlight that purpose. Provide straightforward examples of how you’ll use their donations. Consider including a disclaimer that gifts given after you’ve surpassed your fundraising goal, if there is one, will be redirected toward another need.
- Promoting your general fund: Avoid unintentionally leading donors to make a restricted donation in general fundraising activities. For example, donors may dedicate their gift to a specific program if your donation page provides the option, not intentionally, but simply because they think it’s required when completing the form. Avoid fundraising for a specific purpose on a general donation page.
Open communication should extend to other stakeholders as well, including volunteers, corporate sponsors, and grantmakers. Don’t forget to follow up with progress reports and impact stories to showcase how donors’ funds are used.
4. Create a Fund Summary Document
A fund summary document is an internal document for your nonprofit’s staff that outlines the restrictions and reporting requirements for separate funds. Centralizing this information in a comprehensive document ensures team members across the organization understand fund requirements before making spending decisions.
This document should include:
- The fund’s purpose and description
- Restrictions and limitations
- Reporting requirements, if applicable
Update this document as needed. Additionally, incorporate this document into employee onboarding where appropriate to educate new hires who will interact with restricted funds.
5. Regularly Review Fund Compliance
As funds flow in and out of your organization, keeping a close eye on fund revenues and expenses ensures you consistently use resources according to donor restrictions. Plus, frequent reviews can uncover misuse of funds or unintentional deviations before they become problematic.
Establish a review schedule for evaluating your restricted funds’ net assets monthly, quarterly, or at a different frequency that makes sense for your organization. Clarify what should be examined in these routine reviews.
Ongoing support in this area is a full-time job, meaning your nonprofit should appoint a compliance officer or outsource the task to ensure it’s done correctly. Compare professional accounting and bookkeeping services with your team’s current responsibilities to determine whether this role should be outsourced or assigned in-house.
Keep in mind that your nonprofit isn’t required to accept designated gifts. If a donor places a restriction on their gift that results in your nonprofit being unable to use it, you can always explain the situation and ask them to lift the restriction.
However, when you do accept restricted gifts, they can significantly impact your mission if they’re properly managed.