What Is a Restricted Fund?
A restricted fund is a reserve account that contains money that can only be used for specific purposes. Restricted funds provide reassurance to donors that their contributions are used in a manner they have chosen. Restricted funds most often appear in the context of funds held by certain nonprofits, endowments, or insurance companies.
- A restricted fund is any cash balance that has been earmarked for specific or limited use.
- Often associated with funds held by donations to nonprofit organizations or endowments, restricted funds ensure that donors alone can direct the usage of those assets.
- Failure to comply with restrictions or unauthorized use of restricted funds can result in legal action.
Understanding a Restricted Fund
When a donor gives money to a nonprofit organization, they may specify whether the gift is unrestricted and can be used for any purpose the organization sees fit. If the funds are temporarily restricted, they must be used for a specific purpose. With permanently restricted funds, the donation acts as principal on which interest can be earned (and only the interest is to be spent).
If a donor restricts a nonprofit organization to allocate restricted funds to a specific purpose, it is required to do so by law. Failure to comply may result in the donor taking legal action and reporting the nonprofit to the Office of the Attorney General.
Usually, endowments are considered restricted funds. Their principal usually cannot be spent, and only a specified percent of the interest they earn can be spent per year. Furthermore, there are restrictions on how the interest can be spent. For example, it may be used only to fund scholarships and professorships.
Designation of a Restricted Fund
The donor determines if the funds are to be restricted. Typically, fund designation is specified in writing or through an understood agreement with the nonprofit. Foundations that provide restricted funds often describe how they want their money allocated when they distribute the award. Nonprofit organizations can avoid confusion about how they intend to spend a donor’s funds by offering a choice of designation. For example, a cancer research nonprofit could give donors a choice to allocate their funds to either breast, skin, or brain cancer clinical trials.
Restricted Fund Management for Nonprofit Organizations
Typically, restricted funds are not required to be placed into a segregated bank account, but they must be accounted for separately in a nonprofit’s financial statements. When budgeting, nonprofits should separate restricted and unrestricted funds so that they allocate the money they have to spend correctly. For example, if $100,000 is budgeted for restricted funds, it cannot be mistakenly spent for unrestricted purposes.
Nonprofit organizations could implement an internal system that alerts management when restricted fund obligations have been met; once the donor’s wishes are satisfied, the excess money can be transferred to unrestricted funds. Nonprofit employees should be trained to identify expenditures that require allocation to restricted funds. When the staff correctly allocates money, it keeps donors satisfied and helps avoid legal disputes.