Your auditors have a name for what happens when restricted grant money gets spent outside its approved purpose: a finding. Funders have a different name for it: a clawback. Understanding the difference between restricted and unrestricted funds isn't optional for an Executive Director. It's one of the clearest lines between a clean audit and a very difficult conversation.
What "Restricted" Actually Means
FASB ASC 958 is the accounting standard that governs US nonprofit financial reporting. Under it, every dollar your organization holds falls into one of two net asset classes: net assets with donor restrictions or net assets without donor restrictions.
Net assets without donor restrictions is the formal term for what most people call unrestricted funds. Your organization can spend them on anything that advances your mission: salaries, rent, supplies, a new copier. No funder approval required.
Net assets with donor restrictions are funds a donor or a grant agreement has placed conditions on. Those conditions specify what the money can be used for, when it can be used, or both. There are two types.
Purpose restrictions mean the funds must be spent on a specific activity. A grant for "after-school programming in zip code 84302" can't be redirected to cover your annual gala, even if the gala is a legitimate fundraising expense.
Time restrictions mean the funds aren't available until a specific date or event. A board-designated endowment may generate income that only becomes available annually. A multi-year grant may release funds in tranches.
One more important distinction: board-designated funds are not restricted funds in the FASB sense. If your board votes to set aside $50,000 for a capital reserve, those funds are still unrestricted. The board can un-designate them. Only external donor restrictions create net assets with donor restrictions.
Why This Distinction Creates Real Risk
The risk isn't theoretical. Here's where organizations get into trouble.
Spending restricted funds on unallowed activities. Using a program grant to cover a general operating deficit, even temporarily and with every intention to pay it back, is a grant violation. If an auditor finds it, it appears in the audit report. If a funder finds it, they may demand repayment.
Treating purpose-restricted funds as cash on hand. Restricted funds in your bank account aren't freely available, even if the balance looks healthy. If your organization holds $200,000 in restricted grants for a program that hasn't launched yet, your actual operating liquidity may be far less than your bank statement suggests.
Forgetting time restrictions exist. A multi-year grant that releases $75,000 per year isn't $225,000 of available cash in year one. Recording it that way overstates your net position and can mislead your board.
Misclassifying indirect cost recovery. When grant budgets include indirect cost recovery (overhead), that recovered amount is typically unrestricted, but only if your cost allocation methodology is documented and defensible. Without documentation, auditors may challenge it.
What "Release from Restriction" Means
When your organization spends restricted funds on an allowable activity, you don't just debit the expense account. You also record a release from restriction, a journal entry that moves the amount from net assets with donor restrictions to net assets without donor restrictions.
This entry is how your financial statements show that restricted funds were used appropriately. It appears as a line item on your Statement of Activities: "Net assets released from restrictions."
The release is triggered by one of two things:
- Satisfying the purpose restriction: the allowable expense has been incurred
- Passage of time: the time restriction has elapsed
If your accounting software doesn't support release-from-restriction entries as a native transaction type, you're likely tracking this manually in a spreadsheet, which creates reconciliation risk and is one of the most common sources of audit adjustments.
What Your Finance Director Needs from You
As Executive Director, you're probably not recording journal entries. But you are making decisions that affect restricted fund balances: approving program spending, signing grant agreements, authorizing budget reallocations.
A few habits that protect your organization:
Read the grant agreement before you sign it. Look specifically for purpose restrictions, reporting timelines, indirect cost rates, and any language about prior approval requirements for budget modifications.
Ask about fund balances in budget terms, not just cash. Before approving a significant unbudgeted expense, ask your Finance Director how much of your current cash is unrestricted. A board that only reviews total cash balances can approve spending that doesn't exist.
Know your indirect cost rate and have it documented. Whether you're operating under a negotiated indirect cost rate agreement or a de minimis rate under 2 CFR 200, it should be applied consistently and documented in writing.
Don't approve mid-year budget reallocations on restricted grants without checking the agreement. Many grant agreements require written funder approval before spending can be shifted between budget categories, even within the same grant.
The Bottom Line
Restricted and unrestricted funds aren't accounting labels. They're legal commitments. Understanding the difference, and making sure your financial systems enforce it, is one of the highest-leverage things an Executive Director can do to protect the organization.
Fund accounting software built for nonprofits enforces these distinctions at the transaction level, so a restricted grant can't accidentally absorb an unallowed expense. That's not a nice-to-have feature. It's what makes your audit defensible.
Want to go deeper? The Nonprofit Accounting Guide at cistemission.com covers net asset classes, functional expense allocation, and 990 prep in detail — written for finance teams, readable by everyone else.