The $200,000 Mistake: Why Mixing Restricted and Unrestricted Funds Can Sink Your Non-Profit

The phone call came on a Tuesday afternoon.

"We need to discuss the grant report you submitted," said the program officer from the foundation. Her tone was careful, measured—the kind of voice people use when delivering bad news.

The executive director of a small workforce development non-profit in Atlanta listened as the program officer explained: the grant report showed the $200,000 capacity-building grant had been spent on general operations. Salary costs that were supposed to be covered by unrestricted funds had been charged to the restricted grant. The financial report didn't match the narrative report. And the foundation wanted answers.

Within a week, the non-profit was under formal review. Within a month, they'd been required to return $87,000 in "misspent" funds. Their reputation with one of their largest funders was in tatters.

The tragedy? This organization wasn't trying to cheat anyone. They simply didn't understand fund accounting.

What Are Restricted Funds, Really?

When a donor gives money to your non-profit with specific instructions on how it must be used, that's a restricted gift. The restriction is a legal obligation—not a suggestion, not a preference, but a binding requirement.

Restrictions come in two flavors:

Temporarily Restricted Funds

• Purpose restrictions: "Use this for your after-school program"
• Time restrictions: "Use this in 2026"
• Both: "Use this for capital improvements within three years"

Once the restriction is satisfied (the purpose is fulfilled or the time passes), these funds become unrestricted.

Permanently Restricted Funds

• Principal must be maintained forever
• Only investment earnings can be spent (and sometimes those are restricted too)
• Common with endowments

Unrestricted Funds

• No donor-imposed limitations
• Your board decides how to use them
• The most flexible—and often the scarcest—type of funding

Why This Matters More Than You Think

Fund accounting isn't just an accounting technicality. It has real consequences:

Legal Liability

Spending restricted funds on non-approved purposes is a breach of the donor's trust—and potentially illegal. State attorneys general have authority to investigate non-profit misuse of charitable funds.

Funder Relationships

Foundations talk to each other. One misreported grant can damage relationships across your entire funding ecosystem. Many funders now review your Form 990 Schedule D (which discloses temporarily restricted balances) before making grant decisions.

Board Fiduciary Duty

Your board has a fiduciary duty to ensure donor restrictions are honored. Directors can be personally liable for knowingly allowing restricted fund misuse.

Cash Flow Chaos

If you're spending restricted funds on operating expenses, you're creating a hidden liability. Eventually, you'll need to fulfill that restriction—but the money will be gone.

The 5 Fund Accounting Fundamentals Every Non-Profit Must Master

Fundamental #1: Track Restrictions at the Transaction Level

Every dollar that enters your organization with a restriction must be tagged—and that tag must follow the money through your entire accounting system.

Bad practice: Recording a $50,000 program grant as general revenue and "remembering" it's restricted.

Best practice: Creating a fund or class code for each significant restricted gift, and coding every related transaction to that fund.

Fundamental #2: Document Restrictions in Writing

When you receive a restricted gift, create a permanent record that captures:

• Donor name and contact information
• Exact restriction language (quote the grant agreement or donation form)
• Any reporting requirements
• Timeline for use (if applicable)
• What happens if the purpose becomes impossible

This documentation will save you when questions arise—and they will.

Fundamental #3: Recognize Revenue Correctly

Under ASC 958 (the accounting standard for non-profits), you must distinguish between:

Contributions without donor restrictions: Recognize as revenue when received (or pledged, for unconditional pledges).

Contributions with donor restrictions: Recognize as revenue when received, but report separately as "net assets with donor restrictions."

Conditional contributions: Don't recognize until conditions are met. That $1 million grant that requires a matching donation? It's not revenue until you raise the match.

Fundamental #4: Release Restrictions Properly

When you spend restricted funds on their intended purpose, you "release" the restriction. This is recorded as:

• A decrease in net assets with donor restrictions
• An increase in net assets without donor restrictions

The key: Releases should only occur when expenses meeting the restriction have been incurred. Not before. Not as a year-end cleanup.

Fundamental #5: Reconcile Monthly

Every month, reconcile your restricted fund balances. For each fund:

• Beginning balance
• Plus: new contributions
• Minus: releases (expenses incurred)
• Equals: ending balance

If the ending balance is negative, you have a problem. You've spent money you were supposed to use for something else.

Real-World Scenario: How Fund Accounting Should Work

Let's follow a $100,000 grant through proper fund accounting:

January 15: You receive a grant for youth literacy programs, to be spent by December 31.

Entry: Debit Cash $100,000; Credit Revenue-With Donor Restrictions $100,000

Throughout the year: You spend $75,000 on program staff, supplies, and activities that qualify under the grant.

Entry: Debit Program Expenses $75,000; Credit Cash $75,000 Entry: Debit Net Assets With Restrictions $75,000; Credit Net Assets Released From Restrictions $75,000

December 31: You've spent $75,000 of the $100,000 grant. Your books show:

• $25,000 remaining restricted balance (a liability—you still owe the funder those services)
• $75,000 in program expenses supported by the grant
• A clear audit trail showing exactly where grant dollars went

The following year: You either spend the remaining $25,000 on approved purposes, or you contact the funder about modifying the grant terms or returning unused funds.

Warning Signs Your Fund Accounting Needs Attention

How do you know if your organization has fund accounting problems? Watch for these red flags:

Red Flag #1: You can't produce a restricted fund balance report within 10 minutes. If your system can't instantly tell you how much you have in each restricted fund, you don't have proper fund accounting.

Red Flag #2: Your restricted fund balances only get reviewed at year-end. Annual reviews aren't enough. By the time you discover a problem, you've had 12 months to make it worse.

Red Flag #3: You have negative restricted fund balances. This means you've spent restricted money on other things. It must be addressed immediately.

Red Flag #4: Your development team and finance team have different numbers. If your grant manager says you've received $500,000 in restricted grants, and your accountant says $475,000, someone's wrong—and donor reports are going out with incorrect information.

Red Flag #5: You're "borrowing" from restricted funds for cash flow. This is more common than non-profits admit. "We'll pay it back when the unrestricted pledge comes in." But what if that pledge doesn't materialize?

Building a Sustainable Fund Accounting System

Proper fund accounting requires three elements:

1. The Right Software Setup Your accounting software must support fund or class tracking. QuickBooks, Xero, Sage Intacct, and other platforms all offer this capability—but it must be configured correctly from the start.

2. Clear Policies and Procedures Document how restricted gifts are recorded, tracked, reported, and released. Train everyone who touches financial data.

3. Regular Oversight Monthly fund balance reviews. Quarterly grant report reconciliations. Annual training refreshers. Fund accounting is not "set and forget."

The Path Forward

The Atlanta organization we mentioned earlier did recover—eventually. They implemented new fund accounting systems, hired experienced staff, rebuilt funder relationships one grant at a time.

But they'll tell you: prevention would have been far easier than the cure.

If you're uncertain about your fund accounting practices, now is the time to assess. Before the funder calls. Before the auditor questions. Before a small tracking error becomes a $200,000 problem.

Need help with grant accounting and fund tracking? Our team specializes in non-profit fund accounting, grant compliance, and funder reporting. Schedule a consultation to review your current practices and identify opportunities for improvement.

This article provides general information about fund accounting principles. Specific situations may require different approaches depending on donor agreements, state law, and organizational circumstances. Consult with a qualified CPA for advice tailored to your organization.