Restricted and Unrestricted Liquidity: Advice for Nonprofits

March 23, 2023

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For nonprofit organizations in the arts and culture space, a clear understanding of liquidity is fundamental to lasting success. Sufficient liquidity is vital to ensure the nonprofit can fund programs, meet payroll obligations, and cover other operating expenses. 

Building clear policies and tracking mechanisms to accurately monitor liquidity should be a key focus for any business or organization. But for nonprofits responsible for managing both restricted and unrestricted funds, accuracy in this regard is even more important. 

Effectively tracking liquidity, particularly given the complications of having both restricted and unrestricted funds, is an aspect of internal governance that some nonprofits struggle with. Mistakes have the potential for significant downside risk and an inadequate approach can leave the nonprofit exposed to potential legal, financial and reputational damages. 

This overview explores several best practices that nonprofits should adopt to effectively manage their restricted and unrestricted liquidity. In embracing these best practices, nonprofits can ensure they honor agreements with donors and operate with clarity on their cash position. 

Restricted vs. Unrestricted Funds: Key Differences

Before a nonprofit can embrace systems and policies that govern these distinct categories of funds, it’s important they understand the key distinctions between restricted and unrestricted funds.  

What are Restricted Funds?

Restricted funds, also known as funds with donor restrictions, are funds that a donor specifies must be used in a certain way. These funds are typically restricted in one of two ways:

  • Purpose. Donors may specify that their donations are used for a particular purpose, such as to fund a certain program or set up an endowment. Endowments may be required to be maintained in perpetuity i.e. if a donor establishes a $1m endowment for use for a specific program, the nonprofit must maintain a balance of at least $1m (known as the corpus), and may only use investment growth above $1m to fund the program. There are exceptions where an organization can use part of the corpus as long as it is done prudently.  This requires good governance and the proper policies in place. 
  • Time. Donors may agree to make a donation split across a certain period. An example of this would be a $1m donation, spread across four annual payments of $250,000. These future year donations should be treated as restricted funds as they have an implied time restriction. 

Donors may place any restrictions they like on their funds. Purpose and time restrictions can be combined, requiring nonprofits to take a more sophisticated approach to managing these funds within their internal accounting environment. 

It’s often easier for nonprofits to raise restricted funds. Donors like to know that their donations are being channeled toward a certain capital campaign or program, rather than used for general operating expenses. 

What are Unrestricted Funds?

Unrestricted funds, also known as funds without donor restrictions, are funds the nonprofit is free to spend as management deems appropriate. While donors tend to prefer to contribute funds for a specific purpose, it’s important for development teams to raise unrestricted funds too. 

Earned revenues, such as revenues generated by museum admissions or ticket sales for an event, are also considered unrestricted funds and are commonly used to pay for various operating expenses. 

It’s recommended that nonprofit organizations set aside unrestricted funds into an operating reserve: a separate fund containing three to six months of expenses that serves to stabilize a nonprofit’s finances. 

Maintaining an operating reserve ensures that a nonprofit has access to unrestricted funds in case of unexpected drops in income or increases in expenses. Maintaining this reserve removes the need for nonprofits to dip into restricted funds to find additional liquidity in the case of adverse events.  

Capturing Donor Restrictions 

Adopting policies and tracking mechanisms to accurately track the allocation of funds is a vital step toward robust internal governance. This is particularly important for restricted funds. 

This process starts with the documentation required to define the restrictions on the funds. Depending on the donor, this documentation may take one of several forms:

  • Donor Letter: many donors, particularly corporations and foundations, have their own documentation which specifies the requirements of the donation. 
  • Capital Campaign Form: when donors contribute to a capital campaign, they will complete documentation provided by the nonprofit agreeing that their donation will be used for the purposes specified in the capital campaign. 
  • Documentation from the Development Team: when a donation agreement is made in person, via phone, or email, the nonprofit’s development team will present the agreed-upon restrictions in a short form that the donor will sign.

Regardless of how the restrictions are agreed upon, it’s vital the nonprofit captures these in a written agreement signed by the donor. Auditors will review these agreements to ensure restricted funds are being disbursed in accordance with donor agreements. 

Effectively Tracking Restricted and Unrestricted Funds on an Ongoing Basis

A failure to effectively delineate restricted and unrestricted funds often causes larger issues for a nonprofit’s liquidity. Without a system in place to separately track each of these categories of funds, it’s all too easy for nonprofits to run into cash flow challenges

If restricted funds are used for purposes other than those designated by the donor, they must be replenished by the nonprofit. This can impact liquidity since the nonprofit has to use unrestricted funds to replenish restricted funds. 

Misusing restricted funds can also cause issues during a nonprofit audit. In some instances, nonprofits may have to include disclosures on their audited financial statements that acknowledge this error. That could cause issues with donors, damaging the nonprofit’s reputation.

Particularly excessive use of restricted funds for unintended purposes may also prompt auditors to probe whether the nonprofit is a going concern, given that replenishing restricted funds with unrestricted funds may lead to serious and immediate liquidity challenges.  

To ensure funds are used appropriately, it’s vital nonprofits actively monitor their cash flow on a monthly basis. This task typically falls to the Finance and Audit Committee, which should assess cash flow projections at least 12 months in advance. As part of these projections, the nonprofit’s operating cash flows should be separated from restricted funds.  

Smith + Howard: An Experienced Nonprofit Accounting Firm

Accurately tracking restricted and unrestricted liquidity is a complex, but important, element of nonprofit accounting. Success demands nonprofit financial leaders embrace the right tools and frameworks. 

At Smith + Howard, our nonprofit accounting team has extensive experience advising nonprofits across the nation on liquidity policies, frameworks and tracking mechanisms that promote strong internal governance. 

With a client roster including some of the nation’s most prestigious arts and culture nonprofits and a track record of over 50 years supporting the nonprofit sector, our team deeply understands the intricacies of nonprofit accounting. 

Contact an advisor today to learn more about how Smith + Howard can support your nonprofit accounting needs.

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If you have any questions and would like to connect with a team member please call 404-874-6244 or contact an advisor below.