Restricted vs. Unrestricted Funds: The Rule Every Nonprofit Must Understand

A nonprofit can have hundreds of thousands of dollars in its accounts and still be unable to pay its electric bill. That is not a paradox—it is the direct consequence of confusing restricted and unrestricted funds, and it happens to organizations of every size.

Under GAAP as codified in FASB ASC 958, nonprofits are required to classify and report net assets based on whether donor-imposed restrictions exist (FASB 2016). That classification is not optional, and it is not merely an accounting formality—it determines what money you can spend, when, and on what. The Internal Revenue Service reinforces this through the Form 990, which requires organizations to separately report restricted and unrestricted net assets in a way that is visible to the public (IRS 2024).

This post explains what each fund type means in practice, where nonprofits most commonly go wrong, and what healthy fund management looks like day-to-day.

Watch: Restricted vs. Unrestricted Funds Explained

Prefer a visual walkthrough? This short explainer covers the core concepts with real-world examples—built specifically for nonprofit staff, board members, and executive directors who need clarity without the accounting jargon.

Video: EveryCentCounts — Nonprofit Tuesday Series. Watch on YouTube

The Two Categories Every Nonprofit Tracks

FASB ASC 958-210 requires nonprofits to present net assets in two categories: those with donor restrictions and those without donor restrictions (FASB 2016). These replaced the old three-category system (unrestricted, temporarily restricted, permanently restricted) in 2016, but the practical distinction remains the same. The money either comes with instructions, or it does not.

A Real Scenario: Same Month, Two Very Different Pools of Money

Abstract definitions only go so far. Here is how this plays out in a typical nonprofit month—and where the mistake gets made.

Figure 1. Cost allocation for the month. Of $18,500 in total expenses, $11,500 is correctly charged to the restricted grant; $8,500 must be covered by unrestricted funds—$500 more than available.

What Happens When Restricted Funds Are Misused

This is not a gray area. Using restricted funds for purposes outside the donor-imposed condition is a violation of the gift agreement, and in the case of government or foundation grants, it may constitute a breach of contract with repayment obligations. The National Council of Nonprofits identifies misapplication of restricted funds as one of the most common triggers for nonprofit audit findings and funder relationship breakdown (National Council of Nonprofits 2023).

Why Healthy Nonprofits Need Both—and How They Balance Them

Restricted funds are essential for program delivery and funder relationships. Unrestricted funds are essential for organizational survival. A nonprofit that has only restricted funding—however generous—is structurally fragile. It may be able to run excellent programs while being unable to replace a broken server, give a staff member a raise, or absorb a delayed grant payment.

The AICPA recommends that nonprofits maintain a minimum of three to six months of operating expenses in liquid, unrestricted reserves (AICPA 2024). In practice, many small and mid-size nonprofits fall well short of that threshold—not because they lack revenue, but because the majority of their revenue is restricted and cannot be redirected to cover operating shortfalls.

Strategic fund management means actively cultivating unrestricted giving alongside restricted grant funding—and being transparent with donors about why unrestricted gifts are often more valuable to the organization's long-term health than restricted program gifts of equivalent size.

Restricted vs. Unrestricted: Side-by-Side

Sources: FASB ASC 958-210 (2016); IRS Form 990 Instructions (2024); AICPA Nonprofit Audit & Accounting Guide (2024).

Action Steps

1. Set up a separate fund tracking code for every restricted grant in your accounting system. Each grant should have its own cost center or class so expenditures can be reported against that specific restriction without manual reconstruction at audit time. QuickBooks Nonprofit, Aplos, and Sage Intacct all support class-based fund tracking natively.
2. Review your current net asset balances and categorize every dollar as restricted or unrestricted. If you cannot answer “how much of our cash is actually available for operating expenses?” within five minutes, your fund tracking needs attention before your next board meeting or grant report.
3. Build a monthly fund utilization report for leadership and the board. This report should show, for each active restricted fund: the original award amount, cumulative expenditures to date, remaining balance, and grant period end date. Surprises at year-end are almost always preventable with this one document.
4. Create an unrestricted reserve target and track it explicitly. The AICPA recommends three to six months of operating expenses. Set your target, track it quarterly, and make building unrestricted reserves a stated organizational goal—not an afterthought.
5. Before spending any restricted grant dollar on an expense that isn't explicitly listed in the grant budget, get written approval from the funder. Most funders will approve reasonable budget modifications when asked in advance. Almost none of them will overlook undisclosed misapplication discovered during a site visit or audit.