As nonprofits grow and diversify their funding sources, correctly categorizing funds is more important than ever. Donors, auditors and grantors expect clear, accurate reporting. Missteps can lead to compliance issues and financial instability. Improper fund classification can violate donor restrictions, lead to financial misstatements, damage credibility with stakeholders, and impact long-term sustainability.

Quick Takeaways

• Restricted funds must be used for a specific purpose or timeframe set by the donor.
• Deferred funds are received but not yet earned (often tied to future performance)
• Unrestricted funds offer nonprofits the most flexibility, can be used at management’s discretion, and support day-to-day operations.
• Proper classification ensures accurate reporting, strong donor relationships and sound planning.

Understanding the 3 Types of Nonprofit Funds

What Are Restricted Funds?

Restricted funds are donor-designated and can only be used for a specific purpose. They are referred to as net assets with donor restrictions in financial statements. They include:

• Time & Purpose Restricted Funds: For use within a defined time or project scope.
• Restricted Funds in Perpetuity: Often endowments, where the gifts corpus amount are restricted in perpetuity. Generally, only investment income generated from the corpus amount can be spent.

These funds are tracked separately in financial statements to ensure accountability.

What Are Deferred Funds?

Deferred funds are revenues received in advance for services or milestones not yet fulfilled. Examples include:

• Prepaid program fees or event registrations
• Grants with performance conditions
• Membership dues that cover a future period

Until earned, these funds appear as liabilities on the balance sheet, not income.

Quick Tip: Always match deferred revenue recognition to service delivery or milestone completion to stay compliant with GAAP.

What Are Unrestricted Funds?

Unrestricted funds come with no strings attached. They are referred to as net assets without donor restrictions in financial statements. Nonprofits can use them wherever they’re needed most:

• Administrative and operating costs
• Staff salaries
• Launching new programs or initiatives
• Covering emergency expenses

Why Proper Classification Matters

1. Transparency and Compliance

Misusing funds, especially restricted or deferred, can result in IRS scrutiny, grant clawbacks or donor backlash.

2. Better Financial Planning

Knowing what funds are truly available helps leaders budget more accurately and allocate resources effectively.

3. Builds Donor and Stakeholder Trust

Clear reporting reassures donors that their contributions are used as intended, boosting confidence and long-term support.

FAQs- Differentiating Between Restricted, Deferred and Unrestricted Funds

1. What’s the difference between time & purpose restricted funds and funds restricted in perpetuity?
   Time & purpose restricted funds must be used within a certain time or for a project as stipulated by the donor. Restricted funds in perpetuity must be held in permanence, with generally, only the earnings being available for use at the discretion of management.
2. How should nonprofits report deferred revenue?
   Deferred revenue should be recorded as a liability until the organization meets the conditions to recognize it as income.
3. Can unrestricted funds be used to cover budget gaps?
   Yes, unrestricted funds are often used to cover operational shortfalls or unexpected costs.
4. What happens if a nonprofit misclassifies funds?
   It can lead to audit findings, compliance violations, and loss of donor trust or funding.