Restricted Funds Tracking: Ensure Compliance and Transparency

Restricted funds are donations or grants that must be used for a specific purpose designated by the donor. Tracking them requires fund accounting software that tags every transaction with a fund code, maintains separate balances for each restricted fund, prevents overspending, and generates fund-specific financial statements. FASB (ASC 958) requires nonprofits to classify net assets as "with donor restrictions" or "without donor restrictions" on their Statement of Financial Position. Purpose-built tools like Alignmint enforce these restrictions automatically — generic accounting software like QuickBooks does not.

When restricted fund tracking fails, the consequences are real: audit findings, grant clawbacks, damaged donor relationships, and potential legal liability. It almost always comes down to the same root cause — tracking restricted funds in spreadsheets or using software that doesn't enforce restrictions.

What Makes a Fund "Restricted"

Not every designated gift is legally restricted — and this distinction trips up a lot of nonprofits.

Donor-restricted funds come with legally binding conditions. When a donor writes "for scholarships" on their check, or when a grant agreement specifies allowable costs, those restrictions are enforceable. You can't redirect that money without the donor's written permission (or, in some cases, a court order).

Board-designated funds are different. If your board sets aside $100,000 for a building project, that's an internal designation — the board can change their mind at any meeting. It's not a legal restriction, even though it might feel like one.

The two main categories of truly restricted funds:

Temporarily restricted — funds restricted for a specific purpose or time period. A $50,000 grant for your after-school program is temporarily restricted. Once you spend it on the program, the restriction is "released" and the money moves from restricted to unrestricted on your financial statements. A pledge payable over three years has a time restriction — each payment becomes available when the time period arrives.

Permanently restricted — funds that must be maintained forever, with only the investment income available for use. Endowment principal is the classic example. A donor gives $1 million to establish a named scholarship fund. You invest the principal and use the returns to fund scholarships. The $1 million itself can never be spent.

Understanding this distinction matters because your fund accounting software needs to handle both types — and your team needs to know which category each gift falls into at the moment it's received.

Why Getting This Wrong Is So Expensive

We've seen nonprofits treat restricted fund tracking as a "nice to have" — something they'll get around to when they have time. Here's what happens when they don't:

Grant clawbacks are real. If a federal grantor audits your spending and finds that grant dollars were used for unallowable costs, they can demand the money back. We've talked to organizations that had to return $30,000-$50,000 because their tracking was sloppy. That's not a fine — that's money you already spent on programs, and now you have to find it somewhere else.

Donors stop giving. Major donors who restrict their gifts are paying attention. If they ask how their $25,000 was used and you can't give a clear, specific answer, they won't give again. Worse, they'll tell other donors. In the major gift world, reputation travels fast.

Auditors will find it. Restricted fund accounting is one of the first things auditors examine. If your restricted fund balances don't reconcile, if you can't document when restrictions were released, or if you've commingled restricted and unrestricted funds — you're getting an audit finding. Multiple findings can lead to a qualified opinion, which makes it harder to get grants and loans.

The legal exposure is real. In extreme cases, misusing restricted funds can constitute breach of fiduciary duty. Board members can be held personally liable. This is rare, but it happens — and it's entirely preventable with proper tracking.

What Your Software Actually Needs to Do

Here's where most "restricted fund tracking" feature lists become a wall of checkboxes. Let's talk about what actually matters in practice.

Every transaction must be tagged to a fund. When a restricted gift comes in, it gets coded to a specific fund. When an expense is charged against that fund, the balance decreases. This sounds obvious, but you'd be amazed how many organizations are doing this in spreadsheets — manually updating balances after the fact, with no real-time visibility.

Real-time fund balances are non-negotiable. When your program director asks "How much is left in the youth program fund?", the answer should take 5 seconds — not a phone call to the bookkeeper followed by 20 minutes of spreadsheet work. If you can't see your restricted fund balances in real time, you're at risk of overspending before anyone notices.

Overspend alerts prevent the worst mistakes. The most common restricted fund violation is accidental overspending — charging more to a fund than what's available. Your software should flag this before the transaction posts, not after. A simple alert that says "This expense would overdraw the Building Fund by $2,300" prevents the kind of error that leads to audit findings.

Restriction release tracking matters for your financial statements. When you spend restricted funds on their intended purpose, the restriction is "released" — and your Statement of Activities needs to show this as a line item. If your software doesn't track releases automatically, someone is doing it manually at year-end, which means your interim financial statements are wrong.

Inter-fund transfers need documentation. Sometimes funds need to "borrow" from each other — your general operating fund might temporarily cover an expense that should come from a grant fund. This is fine, as long as it's documented as a loan (not a transfer), tracked for repayment, and approved by someone with authority. Your software should enforce this workflow, not just allow it.

Audit trails are your insurance policy. Every transaction touching a restricted fund should have a complete history: who created it, who approved it, when it was modified, and what changed. When an auditor asks "Show me every transaction against Grant Fund #4721," you should be able to pull that report in seconds.

The Spreadsheet Trap

Most nonprofits start tracking restricted funds in spreadsheets. It works fine when you have two or three funds. But here's what happens as you grow:

Number of Restricted Funds	Spreadsheet Reality
1-3 funds	Manageable, but no real-time visibility
4-10 funds	Multiple tabs, formula errors start creeping in
10-20 funds	Full-time job to maintain, audit prep takes weeks
20+ funds	Basically impossible to keep accurate manually

The breaking point usually comes when an auditor finds a discrepancy between the spreadsheet and the general ledger. At that point, the organization has to reconcile every transaction across every fund — sometimes going back years. We've seen this process take 100+ hours.

The fix isn't complicated: use fund accounting software that tracks restrictions natively. Every transaction is tagged at entry. Balances update in real time. Reports generate automatically. The spreadsheet becomes unnecessary.

Best Practices That Actually Work

Document restrictions at the moment of receipt. When a gift or grant comes in, record the restriction terms immediately — not next week, not at month-end. Include the donor's exact language, the restriction type (purpose or time), and any reporting requirements. If you wait, details get lost and assumptions get made.

Train everyone who touches transactions. Your bookkeeper, your development coordinator, your program directors — anyone who enters or approves transactions needs to understand fund coding. One miscoded expense can throw off a fund balance for months before anyone notices.

Review fund balances monthly. Don't wait for the audit. Pull a fund balance report every month and scan for anything that looks wrong — negative balances, unexpected changes, funds that should have activity but don't. Catching errors early is always easier than fixing them later.

Communicate with donors proactively. Don't wait for donors to ask how their restricted gift was used. Send them a fund-specific impact report showing exactly what their money accomplished. This builds trust, encourages future giving, and demonstrates the kind of accountability that sets your organization apart. See our guide on donor-ready financial reports.

Reconcile restricted fund totals to your general ledger. Your total restricted fund balances should match the "with donor restrictions" line on your Statement of Financial Position. If they don't, you have a problem — and it's better to find it yourself than to have your auditor find it.

The organizations that get restricted fund tracking right aren't the ones with the fanciest software. They're the ones with clear processes, trained staff, and a culture that takes donor intent seriously. The software just makes it possible to do it at scale without losing your mind.

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Related:

• Fund Tracking Software — Manage every dollar across all your funds
• FASB-Compliant Accounting — Nonprofit accounting standards explained
• Grant Management Software — Track grant budgets and compliance
• Nonprofit Budgeting Tools — Plan and track by fund
• Fund Accounting — See how Alignmint handles restricted fund tracking