The Different Flavors of Restricted Funds
Many nonprofits rely to a significant extent on contributions or grants intended for specific purposes, known as restricted funds. Nonprofit accounting places great importance on distinguishing between restricted and unrestricted funds to ensure that the donor intent embodied by the restrictions is respected. Whether viewed from a legal, ethical or accounting perspective, this is all well and good.
But what’s simple and appropriate from the perspective of donor intent is far messier when it comes to managing nonprofit finances. Here, the boundary between restricted and unrestricted funds gets blurry or even disappears. Depending on the constraints under which they’re provided, restricted funds will have profoundly different impacts both on available income and the expenses we can incur. By treating restricted funds as a single category—and as distinct from unrestricted funds—we just make managing our finances more difficult.
The different types of Restricted Funds. As financial managers we focus primarily on the relationship between income and expenses. The more clarity we have about this relationship, the better we can direct our fundraising, the more we can use our budget as a planning and management tool, and the easier it will be for us to make strategic choices. Understanding the distinct types of restricted income offers that clarity:
Some restricted funds are available for expenses that must be incurred during the fiscal year. These can be for essential programs, critical overhead, fundraising or for any other essential purpose. If restricted funds were not available for these purposes, unrestricted funds would be utilized, meaning that with respect to this category, restricted funds are interchangeable—fungible—with unrestricted funds.
Restricted funds may cover expenses that you were planning to incur during the fiscal year, but where the spending is contingent upon receipt of adequate funds. Critically, these expenses—like those in the first category—have been budgeted. Here, the restricted funds can also resemble unrestricted funds such as payments for contracted work or other fee-for-service income.
Restricted funds may be received for expenses that will be incurred in future periods. Annual restricted grants commonly do not synchronize perfectly with an organization’s fiscal year, so restricted funds may include funds that fall into this and one of the earlier categories. Income for multi-year grants is generally recorded in the year when the grant is received. Funds in this category will show up as a windfall one year with corresponding expenditures only appearing in subsequent years.
Restricted funds can be designated for work you were not planning to do. This results in both unanticipated income and unbudgeted expenses that offset that income. Funds in this category can either supplement or displace planned expenses.
Understanding these categories can mitigate some of the challenges that result from treating restricted funds as an undifferentiated category.
Development team efforts. Many organizations struggle to align fundraising priorities with programmatic priorities. Annual income goals are often broken down into separate restricted and unrestricted targets but, as we’ve seen, that is less meaningful than distinguishing between funds available to support budgeted expenses and those that are for other purposes.
The utility of the budget. Ideally, the budget does far more than provide assurance that projected income will be available to cover planned expenses. The budget defines in fiscal terms the work that a nonprofit is planning to do during the fiscal year. As such, it encapsulates shared expectations among staff, the Board and others.
The more a nonprofit must adjust its spending because of restricted funds, the more difficult it is to maintain those shared expectations, and the less value the budget will have as a management tool. Restricted funds belonging to the third and forth categories complicate the balance between income and expenses projected by the budget. As a result, juggling restricted fund balances may be at odds with managing to the budget. Unplanned work may result in additional expenses or it may displace work that the budget anticipated. This makes it harder for staff leaders and the Board to know if variances between budgets and actuals are problematic or not. On a year over year basis, financial information loses value when it doesn’t reflect “apples to apples” comparisons. Income may balloon one year because of a multiyear grant only to shrink the following year
Strategic decision-making. Failing to differentiate the particular impacts of the different types of restricted funds makes it harder both to assess an organization’s present condition and then to understand the implications of possible options. Is the Development team focused on raising the most needed funds? A multi-year grant may be a sign of growth, but declining year over year income with stable expenses will make that difficult for some to see. When funds are offered for unplanned work, should you take it? Does the work to be done replace other work or is it in addition? What does that do to expenses?
Understanding that restricted funds come in these different flavors can help pave the way for better tools that can help ameliorate these challenges. In the next post, I’ll present an approach intended to supplement restricted fund accounting that addresses these challenges.
 In 2016, the Financial Accounting Standards Board (FASB) issued new rules for nonprofits: “Accounting Standards Update 2016-14 “Not-for-Profit Entities (Topic 958), Presentation of Financial Statements of Not-for-Profit Entities. These rules are now taking effect and will be apparent in audits of fiscal years that start at the beginning of 2018 and later. The new liquidity reporting requirements are a step in the right direction, though it’s too soon to know how these will play out. My purpose here is to provide a simple framework for financial managers at all levels who are not accountants.
 For many organizations, the distinction between the first two categories will not be meaningful and rarely will a sharp separation be possible. Whether funds belong to one or the other will be influenced by a host of factors including the organization’s perception of and comfort with the associated risks, the importance of the work, perceptions of the likelihood of future funding, etc.
 Permanently restricted funds, or endowment gifts—of which the donor intends that the principal never be spent—technically belong to this category but carry financial management challenges beyond what is being addressed here.