Unrestricted funds are money your nonprofit can use however it sees fit. General donations, event revenue, membership dues, and earned income typically fall here. The board decides how to allocate these funds toward operations, salaries, rent, programs, or anything else the organization needs.

Restricted funds come with strings attached. A donor gives money and specifies what it can be used for. A grant that funds a specific youth mentoring program, a donation earmarked for building renovations, or a contribution designated for scholarship awards are all restricted. You are legally and ethically obligated to use that money only for the stated purpose.

Within restricted funds there are two categories. Temporarily restricted funds (now formally called “with donor restrictions”) have conditions that will eventually be met, either by spending the money on the designated purpose or by a specific date passing. Permanently restricted funds, like endowments, must remain intact indefinitely with only the investment earnings available for use.

The accounting standards updated the terminology in 2016 under ASU 2016-14. Financial statements now use “net assets with donor restrictions” and “net assets without donor restrictions” instead of the old three-tier system. If your financial reports still use the old language, they may need updating.

Why does this matter day to day? Because spending restricted funds on the wrong thing is a serious problem. If a donor gave $10,000 for a specific program and you used it to cover payroll or rent, that’s a misuse of funds. It can trigger issues during audits, damage donor trust, and in some cases create legal liability for the organization and its board members.

The most common mistake small nonprofits make is not tracking restricted funds separately from the start. Money comes in, it goes into the same bank account, and nobody records the restriction. Six months later, nobody remembers which dollars were designated for what. When it’s time to report back to a grantor or prepare financial statements, the information isn’t there.

Proper tracking doesn’t require separate bank accounts for every restricted gift, though some organizations do that for large grants. What it requires is a bookkeeping system that tags restricted contributions when they come in and tracks spending against those restrictions. QuickBooks can handle this with classes or projects if it’s set up correctly.

Your financial statements need to show restricted and unrestricted net assets separately. Donors, grantors, and board members all need to see how much of your money is spoken for and how much is available for general use. Without this breakdown, the board can’t make informed spending decisions. They might approve expenses thinking there’s $50,000 available when $35,000 of it is restricted to a capital project.

If your organization receives grants or designated gifts and your books don’t clearly distinguish between restricted and unrestricted funds, that’s something to fix now rather than later. Getting your small business bookkeeping set up to handle fund accounting properly saves you from painful cleanup work when audit time or grant reporting deadlines arrive.