The Regulator for Charities in England and Wales
1. Most charities are keenly aware of the need to secure their viability beyond the immediate future. To provide reliable services or funding over the longer term, charities must be able to absorb setbacks and to take advantage of change and opportunity. Many provide for this by putting aside, when they can afford it, some of their current income as a reserve against future uncertainties.
2. Underlying much public discussion of charity reserves is the belief that holding significant amounts of reserves is tantamount to hoarding. This belief is likely to persist unless charities justify and explain their reserves position. Our regulatory studies on reserves (studies RS3, RS5 and RS13) show that too many charities still do not explain their reserves, with the most recent study RS13 indicating 57% of charities had no policy but held £3.6bn of reserves. The giving public are not generally concerned with the legal and accounting technicalities. But they are entitled to be reassured that a charity with reserves has good reasons for keeping funds in reserve, and to know what those reasons are. Ideally, a charity would want to show donors and others that it would be irresponsible not to hold the level of reserves it holds.
3. The fact that a charity holds, or does not hold, reserves is not in itself reason either to criticise or to commend the charity. In our view a charity should be judged on whether or not its level of reserves, whatever it is, is justified and clearly explained. Justifying reserves - a central theme of this guidance - does not mean excusing or being defensive about reserves. It means being able to demonstrate, by reference to a charity's current position and future prospects, why holding a particular level of reserves is right for the charity at that time.
4. We explain in this guidance what we think a charity should do to justify its reserves in that sense. Our aim is also to help trustees and senior staff make decisions about reserves levels in a way that is consistent with the legal requirements for the use of charity income, which are explained in paragraphs 29 to 35.
5. Charity trustees are publicly accountable for their stewardship of charitable funds through the preparation of an Annual Report and accounts. Specific requirements are placed on charity trustees to describe within their Annual Report the policies adopted in relation to reserves. These reporting requirements are explained in paragraphs 55 to 57. The key elements that we consider appropriate for a reserves policy are set out in paragraphs 42 to 47 and some of the factors that will inform the trustees in their setting a policy are set out in paragraphs 48 and 49.
6. Responsibility for establishing an appropriate reserves policy lies with the trustees of each charity, as does the responsibility for justifying and explaining what the charity is doing in that respect. It is not for us to substitute our own judgments for those of reasonable trustees who know the business of their charity, who have taken care to plan properly and who have justified their plans.
7. It is our responsibility to concern ourselves with the way in which trustees are managing their resources. Our powers of intervention arise when resources are mishandled or put at risk. But we do not think it helpful to do nothing until things reach that point. Accordingly we believe it our duty to encourage trustees to apply the principles set out in this guidance.
8. If we come across a charity where the trustees have not done this, or where the level or use of reserves seems unjustifiable by any reasonable measure, we will begin by exploring the reasons with the trustees. We will continue to encourage them towards the principles of this guidance. Cases where we have to use any of our statutory powers to secure the necessary changes are likely to be those few in which mismanagement or misconduct persist, charity resources are at risk, or breaches of the law remain uncorrected.
9. For more detailed coverage of the issue and how we discharge our role, you can read our Operational Guidance (OG 43 - Charities' Income Reserves, written primarily for our staff) on our website.
SORP 2005
10. 'SORP 2005' means Accounting and Reporting by Charities - Statement of Recommended Practice. SORP 2005 sets out recommended practice for charities in the preparation of Annual Reports and accounts, the key elements of which are underpinned by the 2005 and subsequently the 2008 Regulations. SORP 2005 and a range of related guidance are available on our website.
11. The following terms are used in this guidance with the same meanings as they have in the SORP 2005. Readers not familiar with SORP 2005 will need to study these meanings carefully to make the best use of this guidance.
Capital
12. In the context of charity law 'capital' means resources which become available to a charity and which the trustees are legally required to invest or retain and use for its purposes. 'Capital' may be permanent endowment, where the trustees have no power to convert it into income and apply it as such, or expendable endowment, where they do have this power.
'An endowment fund where there is no power to convert the capital into income is known as a permanent endowment fund, which must generally be held indefinitely' (SORP 2005 App 3, para 3.3).
13. Income is used in this guidance to describe all resources which become available to a charity and which the trustees are legally required to apply in furtherance of its charitable purposes with a reasonable period of time. Income funds represent that unexpended amount of such resources. Income funds may be unrestricted or restricted to a particular purpose of the charity.
14. Restricted funds are funds subject to specific trusts, which may be declared by the donor(s) or with their authority (eg in a public appeal) or created through legal process, but still within the wider objects of the charity. Restricted funds may be restricted income funds, which are expendable at the discretion of the trustees in furtherance of some particular aspect(s) of the objects of the charity. Or they may be capital (ie endowment) funds, where the assets are required to be invested, or retained for actual use, rather than expended (SORP 2005 App 3, para 3.2).
15. Unrestricted funds are expendable at the discretion of the trustees in furtherance of the charity's objects. If part of an unrestricted fund is earmarked for a particular project it may be designated as a separate fund, but the designation has an administrative purpose only, and does not legally restrict the trustees' discretion to apply the fund. Some trustees have power to declare specific trusts over unrestricted funds. If such a power is available and is exercised, the assets affected will form a restricted fund, and the trustees' discretion to apply the fund will be legally restricted (SORP 2005 App 3, para 3.1).
16. These regulations are The Charities (Accounts and Reports) Regulations 2005 SI 2005 No 572. The 2005 Regulations cover the legal requirements in a number of areas including:
17. The term 'reserves' has a variety of technical and ordinary meanings, depending on the context in which it is used. As in SORP 2005, here we use the term 'reserves' (unless otherwise indicated) to describe that part of a charity's income funds that is freely available. 'Reserves' are therefore the resources the charity has or can make available to spend for any or all of the charity's purposes once it has met its commitments and covered its other planned expenditure.
18. More specifically SORP 2000 defines reserves as income which becomes available to the charity and is to be spent at the trustees' discretion in furtherance of any of the charity's objects (sometimes referred to as 'general purpose' income); but which is not yet spent, committed or designated (ie is 'free'). This definition of reserves therefore normally excludes:
19. There is an argument for saying that expendable endowment and designated income funds ought to be counted as reserves. The argument is that in each case the trustees are free to regard the funds, if they so choose, as available for general purpose expenditure. There are no legal restrictions preventing trustees treating those two types of funds as free, general purpose funds. But there are practical reasons, explained below, why the funds should not normally be regarded as free (though there are exceptions).
20. By contrast, restricted funds can never be regarded as general purpose funds. Restricted income funds do not fall within the scope of reserves as the term is used in this guidance. Nevertheless, the legal principles on the retention of income apply to restricted income funds, as do the principles of justifying and explaining any retention. For the purpose of applying the principles in this guidance it is suggested that trustees treat each restricted income fund as if it were a separate charity. Thus, each material restricted income fund could have its own 'reserve', reflected in an unspent fund balance which should be justified and (if practicable) explained in its own right.
21. When invested an expendable endowment, like a permanent endowment, provides a relatively secure and predictable stream of income. The advantage of an expendable, over a permanent, endowment is that it also gives trustees the option of spending all, or part, of the endowment itself.
22. In reality many charities with an expendable endowment depend on the income it produces to fund core or continuing activities. Expending any of the endowment itself would reduce the income from it and might jeopardise some of those activities. The charity would then either have to increase its income from other sources - which, if that were readily feasible, the charity would surely have tried to do anyway - or have to cut back its activities. The endowment cannot be regarded as free funds if a charity has that degree of dependence on income from it.
23. Trustees who make a regular practice of reinvesting some of their income with a view to building up the principal of the endowment will need to think very carefully about the justification for doing this, since the income should normally be spent.
24. Reinvesting income generated from capital funds does not have the effect, legally, of converting the income into extra capital. The reinvested funds remain income funds and must be treated as such: adding them to the principal does not overcome this obligation.
25. Designation is an administrative act by which trustees may earmark unrestricted funds for a particular project or use, without restricting or committing the funds legally. The designation may be cancelled by the trustees if they later decide that the charity should not proceed or continue with the use or project for which the funds were designated.
26. The act of designating particular funds neither:
27. SORP 2005 requires the reserves policy statement in the trustees’ Annual Report to quantify and explain the purpose of any material funds which have been designated, and where these are set aside for future expenditure the likely timing of the expenditure (SORP 2005 paragraph 55a). SORP 2005 also states that if the trustees set up a designated fund the notes to accounts should explain why trustees have set up such a fund (SORP 2005 para 75b) and be fully described (SORP 2005 paragraph 329) in the note to the accounts. It further states that a brief description should be given of the different types of fund held by the charity, including an explanation of any transfer between funds and allocations to or from designated funds (SORP 2005 para 75d). We expect charities to follow this recommendation and to ensure that the amount of any funds held as designated funds is appropriate to the purpose or use for which the funds have been designated.
28. A charity will not be justified in creating, or transferring resources to, a designated fund where the main purpose of doing that is to allow the charity to show a reduced level of reserves.
29. 'Income reserves' are defined in the 2005 Regulations as "those assets in the unrestricted fund of a charity which the charity trustees have, or can make, available to apply for all or any of its purposes, once they have provided for the liabilities of the unrestricted fund, together with any commitments of the charity and other planned expenditure intended to be met from the assets of the unrestricted fund". There is, however, no specific legal rule about the amount or proportion of a charity's income funds which it is allowed to hold as a reserve.
30. Trustees are under a general legal duty to apply charity funds within a reasonable time of receiving them. With income funds 'apply' can, in practice, be taken to mean 'expend' unless the governing document specifies otherwise.
31. Before trustees can use income funds in a way which does not comply with this duty, they need to have a legal power which overrides this general duty. Holding income funds in reserve rather than expending them is one use that does not comply with the duty, since the trustees are delaying the application of the funds beyond what the law would normally accept as a reasonable time. Trustees therefore need a legal power to hold income funds in reserve.
32. A small number of trustees have an express legal power in their charities' governing document to hold income in reserve instead of expending it promptly. Much more often, trustees will not have an express power and will have to rely on their implied power - a power not written into the governing document but one which the trustees possess in order to take actions which are necessary for the charity to function properly. As with all discretionary powers, trustees are justified in exercising their power to hold income reserves - whether express or implied - only if in their considered view it is necessary in the charity's best interests to do so.
33. If it is done without justification, the holding of income in reserve may amount to a breach of trust. In paragraphs 40 to 49 we give our view on what steps trustees should take to be sure that they have justified the holding of reserves.
34. Some trustees have in their governing document a power to convert income into capital, which is not the same as a power to hold income in reserve. Converting income into capital takes the converted resource outside the scope of reserves (since our definition of reserves does not include any capital funds).
35. Some charities have reinvested income regularly over a number of years by adding it to the principal of their expendable or (as the case may be) permanent endowment. If they have not kept precise records they may now be unable to specify exactly what portion of the invested funds represents income and what portion represents capital. We would nevertheless expect a charity to be able to make an estimate of the size of the respective portions. We will not, as a general rule, require charities to draw up plans for spending the income portions immediately. But we may ask a charity to justify any plans it has for continued retention of those income funds. If in future the charity intends to reinvest income as it arises we may ask it to justify that too.
36. If a charity has more resources than it could reasonably need to fulfil all of its purposes, the trustees should contact us. The law requires that charitable resources are applied for charitable purposes, even if trustees cannot find a way of using those resources within their existing objects. In the case of an unincorporated charity, we can help by making a Scheme altering the governing document to allow the charity to use its resources more widely than its existing objects permit. Trustees have a legal duty (under s.13(5) of the Charities Act 1993) to apply for such a Scheme where it is appropriate. Our guidance Changing your Charity's Governing Document (CC36) gives more information. Further information is also contained in our Operational Guidance (OG1 - Orders and Schemes, written primarily for our staff) on our website. An unincorporated charity whose income did not exceed £10,000 in its last financial year and which does not hold designated land can use section 74C of the 1993 Act to amend its purposes so it is able to apply its resources. Charitable companies can also amend their objects provided they obtain our prior written consent under section 64 of the 1993 Act.
37. Income is generally exempt from direct tax if it is both applicable, and actually applied, for charitable purposes only. H M Revenue and Customs normal practice is to allow tax exemption on income which either has been expended for charitable purposes or has been invested for the benefit of the charity.
38. Tax exemption is not available if either:
39. People who give or leave money to charities do not usually specify whether their donation or legacy should be treated as income or as expendable endowment. If any evidence exists, or can be inferred from the circumstances of the donation or legacy, that a donor or testator had a specific intention one way or the other, the charity must treat the gift or legacy accordingly. But if there is no such evidence the donation should be treated as income and the trustees should use it in any way they think will benefit the charity that is consistent with the terms of the charity's governing document.
40. Paragraph 55(a) of the SORP 2005 requires trustees to include a statement in their Annual Report about the level of reserves held and the reasons for this (see paragraph 56 below for more guidance on this). To justify their holding of reserves, trustees should have a reserves policy based on a realistic assessment of their reserves needs.
41. A charity which builds up reserves by retaining, as a matter of habit alone, any annual surpluses it makes will scarcely be able to justify holding those reserves.
42. In some (larger) charities the policy will be proposed by senior employees or by a sub-committee of the trustee body, but it should be formally agreed by the trustees acting as a board and recorded in writing.
43. The policy should cover as a minimum:
44. We stress that the amount of time spent preparing the policy, and the detail with which it is set down, should be in proportion to the scale and complexity of the charity's affairs. A small charity with a simple, stable pattern of receipts and payments, few if any commitments, and little susceptibility to outside influences should be able to cover the matters above relatively quickly and to record briefly the trustees' conclusions.
45. Without a reserves policy trustees cannot be confident that their reserves level matches the charity's needs at the time. The charity could be holding reserves that are too high or too low for its needs. If a charity's reserves are too high, it is retaining income funds without justification. Those funds ought to be expended for charitable purposes. While the funds remain in the trustees' hands the charity's current users or beneficiaries - actual or potential - are not being as well-served as they could be.
46. If a charity's income is volatile or insecure, it has high commitments, and its state of affairs is highly susceptible to factors outside its own control, it may find that its reserves are too low to protect it from the risk of insolvency or serious disruption to its charitable work.
47. Some charities will be able to justify holding a certain level of reserves but will be unable to build up reserves to that level, or perhaps to any level at all. Many recently established charities, in particular, will be in that position. While we accept that some charities will simply not have had the resources to establish any reserves, we would still expect a charity in that position to have given thought to a reserves policy even if it currently has no reserves.
48. A charity's reserves policy should be informed by:
49. Trustees who hold reserves without making any attempt to relate their need for reserves to factors such as these will probably have great difficulty explaining in any convincing way why they hold those reserves.
50. Any charity could find its reserves subject to scrutiny and comment in the public arena. Charities which are likely to attract the most attention, especially if they hold sizeable sums as reserves, are those:
51. There is a risk that charities in that position could be seen as self-indulgent, because they are retaining funds which could be used with immediate effect to alleviate acute need. Compliance with the requirements in SORP 2005 and providing a clear and positive explanation of the reasons why reserves are held will greatly reduce this risk.
52. We believe that once a charity has taken the trouble to explain its reasons, the great majority of its donors, supporters and users/beneficiaries will be quite prepared to accept that it should hold appropriate reserves.
53. Charities applying to statutory or voluntary funders are also likely to have their reserve levels closely assessed.
54. Commentators, funders, charities and ourselves all have a part to play in promoting a better-informed treatment of the subject of reserves. The following paragraphs are concerned with charities' reporting of their reserves. We set out below what is required by SORP 2005 and how trustees should set about complying with those requirements.
55. A charity's purpose in reporting on its reserves is to disclose the level of them and to explain convincingly why it needs to retain them at that level.
56. Paragraph 55(a) of SORP 2005 requires trustees to include in their Annual Report information about their charity's reserves policy and the level of reserves held. In particular, trustees should:
57. Paragraph 21 of SORP 2005 states that "a departure [from the recommendations of SORP 2005] is not justified simply for the purpose of presenting to the reader a more appealing picture of the financial position or results of the charity".
58. Every charity is responsible for ensuring that its appeals do not misrepresent the charity's financial position. This is the case whether the appeals are for voluntary public donations, corporate donations, legacies, grants, or any other form of income, and whether they are made by advertising, direct mail, in person, or by any other method.
59. If a charity is widely believed to have large reserves, appeals for further funds may provoke resentment against the charity for apparently seeking funds which it does not need. In wording its appeals, and in dealing with any reaction to the appeals, it should take care not to give anyone the wrong impression about the extent or urgency of its need for funds.
The principal changes in this version of this guidance compared to the previous (April 2002) version reflect the requirements introduced by SORP 2005 and the 2005 Regulations for including in the trustees' Annual Report information about a charity's reserves (see especially paragraphs 55 to 57).
Other minor and consequential amendments have also been made to keep the text as up to date as possible and to refer readers to the Operational Guidance on this issue available on our website.
We would be particularly interested in receiving feedback as to how useful this feature is to readers. As with any other feedback or suggestions for improvements to our publications, please write to the Head of Publications at our Taunton office. Readers should note that a completely new revision of this guidance is being undertaken in the autumn of 2008 to reflect our new publications style and developments in good practice and the reporting of reserves.
For further information you may find it useful to refer to the following Charity Commission publications:
CC3 - The Essential Trustee: What you need to know
CC8 - Internal Financial Controls for Charities
CC12 - Managing Financial Difficulties and Insolvency in Charities
CC15a - Charity Reporting and Accounting: The essentials April 2008
CC36 - Changing your Charity's Governing Document
CC60 - The Hallmarks of an Effective Charity
RS3 - Charity Reserves
RS5 - Small Charities and Reserves
RS13 - Tell It Like It Is: The extent of charity reserves and reserves policies