Are You Recording Donor-Restricted Funds Correctly? Best Practices for Nonprofits

When a conditional contribution becomes unconditional, it’s time for your organization to recognize it as revenue. But that’s not the end of the story—another critical question follows:

Does the contribution include donor-imposed restrictions?
If the answer is yes, you now have a donor-restricted contribution, and it must be accounted for properly.

Mismanaging restricted funds can lead to compliance issues, donor mistrust, and even legal consequences. In this article, we’ll break down the types of donor restrictions, outline your responsibilities under GAAP, and provide practical tips to help your nonprofit stay organized, transparent, and audit-ready.

Understanding Donor Restrictions: The 3 Types

Donor-restricted contributions are classified into three categories:

1. Purpose-Restricted Funds

These funds must be used for a specific project or activity defined by the donor.

Examples:

• A $50,000 donation earmarked for building a new shelter.
• A grant designated for after-school STEM programs.
• Contributions to a mission fund, scholarship, or disaster relief initiative.

When to Release:
Funds are released from restriction once the specific purpose has been fulfilled.

2. Time-Restricted Funds

These contributions can only be used after a certain date or over a defined period.

Examples:

• A multi-year pledge payable in installments.
• An endowment fund where investment income can be spent only after a future date.

When to Release:
Funds are released once the specified time period has elapsed or the payment is received, depending on the terms.

3. Permanently Restricted Funds (Endowments)

These gifts require the principal to be maintained in perpetuity, with only the earnings available for use.

Examples:

• A $100,000 endowment to fund annual scholarships, with only investment income used.
• A bequest where only dividends or interest can be spent.

When to Release:
Only the investment earnings are released when used for their designated purpose. The original gift remains permanently restricted.

Accounting & Reporting Requirements (Under GAAP)

Proper accounting for restricted contributions isn't just best practice—it’s a legal and fiduciary responsibility. Here’s what you need to do:

Track Restricted Funds Separately
Use fund accounting software or organized spreadsheets to maintain separate balances for:

• Unrestricted net assets
• Donor-restricted (temporary and permanent) net assets
  

Document Every Restriction
Clearly record the nature of each restriction (purpose, time, permanent) at the time the gift is received. Keep a copy of the donor agreement or communication on file.

Monitor & Release Restrictions
Set up internal controls that alert management when a restriction is met. Once met, move funds from “restricted” to “unrestricted” net assets in your accounting system.

Report Transparently
Provide donors and your board with clear reporting on how restricted funds were used. Demonstrating alignment with donor intent builds trust and strengthens long-term support.

Internal Controls & Staff Training

To avoid compliance issues, your nonprofit should implement a reliable internal process:

• Establish workflows for program managers and finance staff to tag expenses to restricted funds.
• Train staff to understand donor agreements and how to identify qualifying expenditures.
• Review fund activity regularly to ensure that releases are timely and documented.

Example: If a donor contributes $25,000 for youth education programs, ensure that related program expenses (e.g., supplies, staff time) are coded appropriately and used to release the funds from restriction once used.

When to Recognize Revenue

Under GAAP, here's how to recognize revenue:

• Conditional contributionsare not recognized until all conditions are substantially met.
• Once a contribution isunconditional but restricted, recognize it as revenue under net assets with donor restrictions.
• Move tounrestricted net assets only when the time or purpose restriction is fulfilled.
• Forpermanent restrictions, recognize the revenue but retain the principal in the restricted category indefinitely; only earnings can be released when used.
  
  

Why It Matters

Failing to properly manage restricted funds can lead to:

• Legal consequences, if funds are misused
• Loss of future funding, if donor trust is damaged
• Audit findingsor compliance issues under FASB or state charitable registration laws
  
  

Final Thoughts

Donor-restricted contributions are a vital part of nonprofit funding—but with them comes the responsibility to manage and report them properly. With strong processes, accurate accounting, and proactive communication, your organization can ensure transparency, honor donor intent, and maintain compliance.

If you have questions about how to classify, track, or report donor-restricted funds—or if you'd like a review of your current practices—we’re here to help. Leave a comment below or feel free to contact me directly!