How to Handle Restricted Funds in the General Ledger

When Canadian charities and nonprofits receive donations with specific purposes attached, they face unique accounting challenges in their general ledger.

These restricted funds require separate tracking from regular operating money. Mistakes can lead to compliance issues with the Canada Revenue Agency or damage donor relationships.

Organizations must set up distinct fund codes in their general ledger for each type of restriction.

They should record all restricted donations in these separate accounts immediately upon receipt. Clear documentation must connect each transaction to the donor's original intent.

The general ledger serves as the foundation for tracking restricted funds properly throughout their lifecycle.

Canadian organizations need to know how to create account structures, record initial donations, track expenses against restrictions, and report these activities accurately on financial statements.

The process involves more than simply noting which funds have limitations. It requires systematic procedures that protect both the organization and the donor's wishes.

This guide explains practical steps for handling restricted funds in a Canadian general ledger context.

It covers Canadian regulatory requirements, technical accounting entries, and internal controls that prevent errors.

Organizations will learn how to structure their chart of accounts and allocate expenses correctly.

The guide also explains how to produce financial statements that meet Canadian reporting standards while maintaining donor trust.

Understanding Restricted Funds and Their Significance

Restricted funds are money that donors or granting bodies have designated for specific purposes. Charity organizations must track and spend these amounts according to explicit conditions.

Proper handling of restricted donations is essential for maintaining charitable status and donor trust in Canada.

Definition of Restricted Funds

Restricted funds are donations or grants with specific conditions on how they must be used.

Donors dictate the purpose, project, or timeframe for spending these funds.

These restrictions create a legal and ethical obligation for charities. Organizations must use the money exactly as the donor specified.

Breaking these restrictions can lead to serious consequences, including loss of charitable registration status with the Canada Revenue Agency (CRA).

Restrictions should be documented in writing whenever possible. Clear communication between donors and charities prevents confusion about how funds should be spent.

Organizations need separate tracking systems to ensure each restricted fund stays isolated from general operating money.

Common Types of Donor Restrictions

Purpose restrictions limit funds to specific programs or activities. For example, a donor might give money only for youth programming or food bank operations.

Time restrictions require organizations to use funds within a certain period or after a specific date.

Some donors specify that their contribution must be spent in the current fiscal year or held until a future project begins.

Project restrictions tie funds to particular initiatives. Examples include:

• Building campaigns for new facilities
• Equipment purchases
• Scholarship programs
• Research projects
• Community outreach initiatives

Restricted grants from foundations or government agencies often combine multiple restriction types. They might specify both the program area and the time period for spending.

Restricted vs. Unrestricted Funds

Unrestricted funds give charity organizations flexibility in how they allocate money across operations and programs.

Charities can use these donations for any purpose that aligns with their mission and charitable activities.

Restricted funds require strict adherence to donor specifications. Organizations cannot redirect these funds without donor permission, even when other needs seem more urgent.

Both fund types must support the organization's charitable purposes under the Income Tax Act.

The key difference is who controls spending decisions—donors control restricted funds while the board of directors manages unrestricted funds.

Canadian Regulatory Framework for Restricted Funds

The Canada Revenue Agency sets rules for how registered charities must handle restricted funds. There are strict requirements for tracking, reporting, and maintaining donor trust.

Non-compliance can result in penalties, audits, or loss of charitable status.

Overview of CRA Guidelines

The CRA requires charities to maintain separate accounting for restricted and unrestricted funds in their financial records.

Charities must track all donor-imposed restrictions from the moment they receive donations and ensure these funds are used as donors intended.

Financial statements must clearly separate net assets with donor restrictions from unrestricted net assets.

The CRA expects charities to show this distinction on their balance sheets and in their statements of activities.

Each restricted fund needs its own account code or tracking system within the general ledger.

Charities must file annual T3010 information returns that detail restricted fund activities.

These returns require organizations to report how they received, spent, and managed restricted donations throughout the year.

The CRA reviews these returns to verify proper fund management and financial transparency.

Key documentation requirements include:

• Written records of all donor communications and gift agreements
• Clear tracking of restriction types and spending timelines
• Detailed notes in financial statements explaining restrictions
• Reports showing how restricted funds were allocated to programs

Legal Compliance and Consequences

Mismanaging restricted funds can lead to serious legal problems for nonprofit and charity organizations.

The CRA can revoke charitable status if a charity uses restricted funds for purposes that do not match donor intent.

Penalties for non-compliance include fines, mandatory audits, and suspension of tax receipting privileges.

The CRA may impose financial penalties equal to 110% of the misused amount, which the charity must return to similar qualified donees.

Charities face additional consequences beyond CRA action. Donors can pursue civil lawsuits if organizations breach gift agreements or use restricted funds improperly.

These legal actions damage donor trust and harm the charity's reputation in the community.

The CRA conducts regular audits to verify restricted fund compliance. Organizations selected for audit must provide complete documentation showing proper fund separation, tracking, and usage.

Failing an audit can trigger ongoing monitoring requirements or immediate corrective action orders.

Donor Intent and Obligations

Charities have a legal obligation to honour donor intent as expressed in gift instruments and written communications.

Donor intent forms the foundation of all restricted fund management and cannot be altered without explicit donor permission.

Organizations must document donor intent clearly at the time of receipt. This includes capturing the exact wording of restrictions, time limitations, and any reporting requirements the donor expects.

Written confirmation helps prevent disputes and ensures financial transparency.

When circumstances make following restrictions impossible, charities must contact the donor for guidance.

If the donor is unavailable or deceased, organizations may need court approval to modify restrictions through a cy-près application.

This legal process ensures changes align with the donor's original charitable purpose.

Charities should communicate regularly with donors about restricted fund usage.

Transparency builds donor trust and demonstrates accountability.

Reports should show how much was spent, what outcomes were achieved, and what balance remains for future use.

Fund Accounting in Canadian Charity Organizations

Fund accounting creates separate financial records for different types of money a charity manages.

Each fund acts like its own accounting system with assets, liabilities, revenues, expenses, and net assets that balance independently.

Principles of Fund Accounting

Fund accounting separates money based on donor restrictions and organizational needs rather than treating all resources as one pool.

Canadian charities establish funds to track contributions with specific purposes and show accountability to donors and regulators.

The operating fund holds unrestricted money that covers day-to-day activities and general expenses.

Restricted funds hold donations designated for specific purposes like building projects or program activities.

Endowment funds preserve donated capital while using only the investment income.

Each fund maintains its own set of accounts that balance separately.

This means a charity tracks assets, liabilities, revenues, and expenses within each fund independently.

The organization then combines all funds to create complete financial statements.

Fund accounting helps charities prove they use restricted donations correctly.

It also simplifies internal tracking and reduces the risk of accidentally spending restricted money on unauthorized purposes.

Chart of Accounts for Restricted Funds

The chart of accounts for restricted funds uses unique account codes to separate restricted money from unrestricted resources.

Most charities assign different number ranges or prefixes to distinguish between fund types in their fund accounting software.

A typical setup includes account codes starting with different digits for each fund category.

For example, accounts beginning with 1000-1999 might represent the operating fund, while 2000-2999 represent capital asset funds, and 3000-3999 represent endowment funds.

Revenue and expense accounts follow the same numbering pattern within each fund.

This structure allows charities to generate reports by fund and track fund allocation across different restrictions.

Charity bookkeeping becomes more accurate when the chart of accounts clearly identifies each fund's financial activity.

Segregating Net Assets

Net assets represent the difference between total assets and total liabilities within each fund.

Canadian charities must segregate net assets by restriction type on their financial statements to show donors and regulators how resources are allocated.

Organizations report net assets in separate columns or sections for each major fund category.

The financial statements display unrestricted net assets, restricted net assets, and endowment net assets as distinct line items.

This presentation shows stakeholders exactly how much money is available for general use versus specific purposes.

Internal records track more detailed breakdowns within restricted categories.

A charity might have multiple restricted funds for different projects that appear as one restricted net asset total on external statements.

Recording Restricted Funds in the General Ledger

Proper recording of restricted funds requires setting up distinct ledger accounts and making accurate journal entries.

Canadian charities must maintain clear records that show how restricted donations and grants flow through their accounting system.

Setting Up Ledger Accounts for Restricted Funds

The chart of accounts needs separate tracking codes for restricted and unrestricted net assets.

Organizations should create distinct account numbers for each type of restriction based on donor requirements.

Recommended account structure:

• 3000-3999: Net Assets Without Donor Restrictions
• 4000-4999: Net Assets With Donor Restrictions - Temporarily Restricted
• 5000-5999: Net Assets With Donor Restrictions - Permanently Restricted

Each major restricted fund requires its own account code within these ranges.

A capital campaign fund might use account 4100, while a scholarship fund uses 4200.

This structure keeps different restrictions separate in the general ledger.

Organizations handling multiple restricted donations should consider separate bank accounts for significant restricted funds.

This makes reconciliation easier and prevents accidental mixing of restricted money with general operating funds.

The general ledger must track the restriction purpose, any time limitations, and remaining balances for each fund.

Staff need access to detailed notes about what each donor specified when making their gift.

Journal Entries for Restricted Donations and Grants

Recording restricted donations requires specific journal entries that classify funds correctly when received.

The debit always goes to cash or accounts receivable, while the credit goes to the appropriate restricted revenue account.

Example entry for a $10,000 temporarily restricted donation:

Restricted grants follow the same pattern but may require additional tracking for grant conditions.

Organizations should record grant revenue when they receive the funds or meet eligibility requirements, depending on the grant terms.

Permanently restricted donations like endowments need special journal entries that protect the principal amount.

These entries credit permanently restricted net assets rather than temporarily restricted accounts.

Each journal entry must include memo notes explaining the restriction details.

This documentation connects the accounting entry to the original donor agreement or grant contract.

Tracking Fund Expenditures

Expenditures from restricted funds require careful recording to show compliance with donor restrictions. Organizations must document that each expense matches the approved purpose before charging it to a restricted account.

When spending restricted funds, the bookkeeper makes two journal entries. First, they record the actual expense to the appropriate expense account.

Second, they reclassify the restriction by moving the amount from restricted to unrestricted net assets.

Example entries for spending $2,000 from a restricted program fund:

Entry 1 - Record the expense:

• Debit: Program Expense $2,000
• Credit: Bank/Cash $2,000

Entry 2 - Release the restriction:

• Debit: Temporarily Restricted Net Assets $2,000
• Credit: Unrestricted Net Assets $2,000

The general ledger must show a clear audit trail linking expenditures to specific restricted funds. Monthly reconciliation compares actual spending against each fund's balance.

Organizations should run regular reports showing beginning balances, new donations, expenditures, and ending balances for each restricted fund. These reports help management verify that restricted fund balances match donor restrictions and available bank funds.

Financial Reporting and Disclosure Requirements

Canadian charities must present restricted funds separately in their financial statements. This shows donors and regulators exactly how money is being used.

Each major financial statement requires specific disclosure methods that distinguish between restricted and unrestricted net assets.

Statement of Financial Position

The statement of financial position shows restricted funds as separate line items under net assets. Organizations must divide net assets into two main categories: net assets without donor restrictions and net assets with donor restrictions.

Temporarily restricted funds appear as one line item under restricted net assets. These funds have time-based or purpose-based restrictions that will eventually be released.

Permanently restricted funds appear as a separate line item, typically for endowments where only investment income can be spent.

Net assets section format:

• Net assets without donor restrictions (unrestricted funds)
• Net assets with donor restrictions - temporary
• Net assets with donor restrictions - permanent

The notes to financial statements must explain the nature of each restriction. This includes describing what purposes the funds serve and when temporary restrictions might be satisfied.

Organizations should list major categories of restrictions rather than every individual fund.

Statement of Activities and Income Statement

The statement of activities tracks how restricted fund balances change during the reporting period. Revenue from restricted donations appears in the restricted net assets column.

Expenses that satisfy restrictions move funds to unrestricted net assets. Organizations report a net assets released from restrictions line when they spend temporarily restricted funds according to donor wishes.

This line shows the amount transferred from restricted to unrestricted net assets. The statement must clearly show beginning balances, additions, releases, and ending balances for each restriction category.

Permanently restricted fund investment income appears based on donor specifications. If donors allow income to be spent, it moves to temporarily restricted or unrestricted net assets depending on any spending restrictions.

Statement of Cash Flows

The statement of cash flows separates restricted and unrestricted cash receipts to show liquidity constraints. Cash received with donor restrictions appears as a distinct line item in the financing activities section for most organizations.

Restricted cash used for its designated purpose appears in the operating activities section. Organizations must maintain enough detail to track restricted cash movements separately from unrestricted operating funds.

This prevents confusion about what cash is actually available for general operations. The statement must reconcile to the total cash balance shown on the statement of financial position.

Notes should explain any significant restrictions on cash balances that limit the organization's ability to use those funds.

Best Practices for Managing and Allocating Restricted Funds

Proper management requires clear budgeting strategies, strong internal controls, and systems that prevent common errors. Organizations must track fund allocation carefully and maintain oversight through regular audits.

Budgeting and Fund Allocation Strategies

Organizations should create separate budget lines for each restricted fund within their general ledger. This prevents mixing restricted donations with unrestricted operational costs and ensures accurate tracking of how funds are spent.

Budget planning must align with donor restrictions before any allocation occurs. Organizations need to identify which expenses qualify as direct costs under each restriction.

For example, a donation restricted for youth programs cannot cover general administrative salaries unless the donor specifically allowed overhead allocation.

Key budgeting elements include:

• Separate budget codes for each restricted fund
• Clear identification of allowable versus non-allowable expenses
• Timeline tracking for time-restricted donations
• Regular comparison of actual spending against budgeted amounts

Organizations should establish allocation formulas for indirect costs when donor agreements permit overhead charges. These formulas must be consistent and based on reasonable methods such as staff time percentages or square footage calculations.

Documentation of these allocation methods protects the organization during audits and demonstrates proper stewardship to donors.

Internal Controls and Oversight

Strong internal controls prevent misuse of restricted funds and ensure proper segregation of duties. Organizations must require approval from at least two authorized staff members before spending any restricted funds.

Regular reconciliation procedures should compare restricted fund balances against donor agreements and remaining obligations. Monthly reviews help catch errors early and verify that fund allocation matches donor intent.

Organizations need to maintain detailed records of all decisions related to restricted fund spending.

Essential control measures:

• Separate signing authority for restricted fund cheques
• Monthly reconciliation of restricted accounts
• Quarterly internal reviews of fund usage
• Annual external audits for organizations with significant restricted funds

The finance committee or board of directors should receive regular reports on restricted fund activity. These reports must show beginning balances, new donations received, amounts spent, and remaining funds available under each restriction.

Organizations should document any concerns or questions about proper fund allocation in meeting minutes.

Avoiding Common Fund Management Errors

The most frequent error occurs when organizations inadvertently spend restricted funds on unauthorized expenses. This happens when staff lack clear documentation about what each restriction allows.

Organizations must train all staff who handle finances on proper restricted fund procedures. Another common mistake involves failing to track time restrictions properly.

Organizations sometimes forget that certain donations must be spent by specific deadlines or they must be returned to donors. Setting up calendar reminders and regular reporting helps prevent these timing errors.

Errors to prevent:

• Mixing restricted and unrestricted funds in the same account
• Charging expenses to the wrong restricted fund
• Missing donor reporting deadlines
• Failing to document when restrictions are satisfied

Organizations should never assume that leftover restricted funds can be redirected without donor permission. If project costs come in under budget, the remaining funds stay restricted unless the donor provides written approval for other uses.

Maintaining open communication with donors prevents confusion and protects the organization's reputation.

Ensuring Transparency and Building Donor Trust

Charities build strong relationships with donors through honest communication about restricted fund usage and clear financial reporting. Organizations must show exactly how they use restricted donations and maintain accountability systems that protect both donor interests and organizational integrity.

Effective Communication with Donors

Open dialogue with donors starts before accepting restricted gifts. Organizations should discuss whether they can meet specific restrictions and explain any limitations upfront.

This prevents misunderstandings and shows respect for donor intentions. Clear gift agreements document all restrictions in writing.

These agreements should specify exactly how funds will be used, what expenses qualify, and how the organization will report on progress. Both parties need to sign and keep copies of these documents.

Organizations must reach out to donors when circumstances change. If a restricted project costs less than expected or becomes impossible to complete, they need donor approval before redirecting funds.

This communication shows financial transparency and maintains donor trust. Regular updates keep donors informed between formal reports.

Quick emails or calls about project milestones demonstrate that the organization values the donor's investment. These touchpoints strengthen relationships and encourage future giving.

Reporting Usage of Restricted Funds

Detailed reports show donors exactly where their restricted funds went. Financial statements should break down spending by category and connect expenses to specific activities or outcomes.

Numbers alone don't tell the whole story, so organizations should include program results that demonstrate impact. Reports need both financial data and narrative descriptions.

A donor who restricted funds for youth programs wants to know how many young people benefited and what changed in their lives. Photos, testimonials, and measurable results make reports meaningful.

Organizations should send reports on agreed schedules, whether quarterly, semi-annually, or annually. Each report should show the starting balance, money spent during the period, and remaining funds available.

Maintaining Financial Accountability

Strong internal controls prevent restricted fund misuse. Organizations need separate accounting codes for each type of restricted fund in their general ledger.

This separation makes it impossible to accidentally spend restricted money on wrong purposes. Multiple staff members should review restricted fund transactions.

One person records the expense, another approves it, and a third person reconciles accounts monthly. This division of duties catches errors and prevents fraud.

Regular internal audits verify that restricted funds follow donor wishes. Organizations should review all restricted accounts quarterly to confirm spending matches approved purposes.

External auditors also examine these funds during annual audits to provide independent verification. Documentation systems must capture every restricted fund transaction.

Organizations need to keep grant agreements, donor letters, approval records, and expense receipts. These records prove compliance if donors or regulators ask questions years later.

Conclusion

Managing restricted funds in the general ledger requires careful tracking and proper accounting methods. Canadian charities must choose between the Deferral Method or the Restricted Fund Method when using fund accounting.

Both approaches help organizations stay compliant with CRA regulations while maintaining donor trust. Setting up separate accounts for different fund types makes tracking easier and more accurate.

Organizations should maintain clear records of all restricted contributions and ensure funds are used according to donor wishes. This protects the charity's tax-exempt status and builds confidence with supporters.

B&H Charity Accounting Firm helps Canadian charities manage their restricted funds correctly and stay compliant with all reporting requirements. Our team understands the complexities of fund accounting and can guide organizations through proper setup and maintenance.

Call (289) 301-8883 or visit charityaccountingfirm.ca to learn more about specialized accounting services for charities. Schedule a free consultation to discuss specific needs and get expert advice on handling restricted funds in the general ledger.

Frequently Asked Questions

Managing restricted funds raises many practical questions about proper accounting methods and compliance requirements. These common concerns focus on recording procedures, classification differences, and financial statement presentation.

How do I record restricted funds?

Organizations record restricted funds by creating separate accounts in the general ledger. This distinguishes them from unrestricted funds.

The accounting system needs distinct fund codes or account numbers for each type of restriction. When a restricted donation arrives, the organization records it as revenue in the appropriate restricted fund account.

The entry debits cash or accounts receivable and credits restricted revenue in the designated fund. The balance sheet must show these funds under net assets with donor restrictions.

Organizations cannot mix restricted funds with general unrestricted accounts. Each restricted fund requires its own tracking mechanism that documents the donor's original intent, spending requirements, and any time limitations.

This documentation links directly to the general ledger entries for audit purposes.

What type of account is restricted funds?

Restricted funds appear as net asset accounts on the balance sheet. They represent a subset of the organization's total equity, separate from net assets without donor restrictions.

The general ledger classifies restricted funds as either temporarily restricted net assets or permanently restricted net assets. Temporarily restricted funds have limitations that will expire when certain conditions are met or specific time periods pass.

Permanently restricted funds maintain donor restrictions that never expire. These typically include endowment principal that must remain intact indefinitely, though the organization can often use investment earnings according to donor specifications.

Both types function as equity accounts rather than liability accounts. The organization owns these funds, but donor restrictions limit how and when they can be spent.

What is the journal entry for releasing restricted funds?

When an organization spends funds for the donor's designated purpose, it records a release entry. This moves the amount from restricted net assets to unrestricted net assets.

The journal entry debits net assets with donor restrictions and credits net assets released from restrictions. This credit appears as revenue in the unrestricted column of the statement of activities.

The organization records the actual expense in its unrestricted accounts. For example, if it spends $5,000 from a youth program fund on supplies, it debits program supplies expense and credits cash or accounts payable.

The release entry and expense entry can occur at the same time when eligible expenses are incurred. Some organizations record these entries monthly during the closing process. Others record them as expenses happen.

How should a Canadian organization categorize temporarily restricted funds and permanently restricted funds in its ledger?

Canadian organizations use separate account ranges for temporarily restricted and permanently restricted net assets. The account numbering system should clearly show the restriction types.

Temporarily restricted funds have account codes that identify the restriction type and purpose. For example, accounts 3100-3199 can track temporarily restricted program funds, and 3200-3299 can be used for capital funds.

Permanently restricted funds appear in a separate account range, such as 3500-3599. These accounts track endowment principal that must remain intact.

Each major restricted fund should have its own account number. If multiple gifts for the same purpose have similar restrictions, they can be combined under one account code.

The ledger must support financial statement preparation that separates restricted funds from unrestricted net assets. Accounts should be organized to match the required reporting categories on the statement of financial position.

Organizations should use sub-accounts to track details like donor names, grant numbers, or project codes. This tracking supports donor reporting and audit trails.

What are the implications for non-compliance with restricted fund accounting regulations in Canada?

Organizations that misuse restricted funds face serious penalties from the Canada Revenue Agency. The CRA can revoke an organization's charitable status if it fails to honour donor restrictions or maintain proper accounting records.

Donors can take legal action if organizations spend restricted funds on purposes not specified in the gift agreement. These lawsuits can result in court orders requiring repayment of misused funds plus legal costs.

Provincial regulators may impose fines or sanctions on charities that violate restricted fund accounting requirements. These penalties vary by province and can include financial penalties or corrective action plans.

Non-compliance damages donor trust. This can significantly reduce future donations.

Organizations risk losing government grants if they cannot demonstrate proper restricted fund management. Grant agreements usually require strict compliance with accounting standards.

Auditors may issue negative opinions on financial statements that do not properly account for restricted funds. These audit opinions make it difficult to secure future funding from foundations, government agencies, and major donors.