Charities and reserves (CC19)

June 2010

Charities and reserves (CC19) Explains what reserves are, the trustees' responsibility to consider whether their charity needs reserves, and what to bear in mind when developing a policy on reserves.

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Contents

A. Introduction

A1. What is this guidance about?

This guidance is written for trustees of all types of charities, whether they are companies, trusts or associations. It explains what is meant by the term reserves, the trustees' responsibility to consider whether their charity needs reserves, and what to bear in mind when developing a policy on reserves. This guidance is relevant to charities of all sizes. In annex 2 it describes some of the additional factors that may be relevant to larger and more complex organisations when setting a reserves policy.

It also looks at how trustees must report their reserves policy in their annual report in a way that meets the requirements of the Statement of Recommended Practice: Accounting and Reporting by charities (the Charities SORP) and legal requirements of the Charities (Accounts and Regulations) 2008 (the Regulations).

Exempt charities are not required by the Charities Act to prepare an annual report and therefore no specific legal requirement is placed on them to report their reserves policy. However, most exempt charities will prepare an annual report under other requirements. Registered Social Landlords and Higher and Further Education Institutions have their own more specialist SORPs which require the preparation of an annual report. Trustees of exempt charities must therefore consider any specific requirements placed upon them by their own statutory regime and any relevant SORP. We strongly recommend that trustees of exempt charities follow this guidance when setting a reserves policy and report on that policy in their annual report as a matter of good practice.

Similarly, charities which are excepted from registration are not required by charity law to prepare an annual report. Nevertheless, many excepted charities do choose to prepare an annual report. In such cases the annual report should include a statement of their reserves policy in line with the Charity SORP's principles. The Charity Commission can also require excepted charities to file an annual report and in such instances a statement of reserves policy is a legal requirement.

A2. How has the guidance changed?

This guidance updates our previous publication Charities' Reserves (CC19), published in March 2008. It presents the guidance in a new and accessible format and provides additional guidance for trustees on the questions and factors to consider when developing their reserves policy.

A3. What do we mean by 'must' and 'should'?

In this guidance, where we use 'must', we mean it is a specific legal or regulatory requirement affecting the trustees. Trustees must comply with these requirements. To help you easily identify those sections which contain a legal or regulatory requirement we have used the L symbol symbol next to the short answer in that section.

We use 'should' for items we regard as minimum good practice, but for which there is no specific legal requirement. Trustees should follow the good practice guidance unless there's a good reason why they should not.

A4. Terms and definitions

The following terms are used throughout this guidance and should be interpreted as having the specific meanings given below.

Annual report means the Trustees' Annual Report prepared under the Charities Act.

Charities SORP means the Statement of Recommended Practice: Accounting by Charities published by the Charity Commission that was last revised in 2005. It sets out the recommended practice for the purpose of preparing the trustees' annual report and preparing accounts on an accruals basis. The accounting recommendations of the SORP do not apply to charities preparing receipts and payments accounts.

Designated funds are part of the unrestricted funds which trustees have earmarked 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.

Endowment funds are funds which the trustees are legally required to invest or to keep and use for the Charity's purposes. Endowment may be expendable or permanent.

Expendable endowment is an endowment fund where the trustees have the power to convert the property (ie land, buildings, investments or cash) into 'income'. It is distinguishable from 'income' by the absence of a positive duty on the part of the trustees to apply it for the purposes of the charity, unless and until this power to convert into 'income' is actually exercised.

Governing document means any document which sets out the charity's purposes and, usually, how it is to be administered. It may be a trust deed, constitution, conveyance, will, memorandum and articles of association, Royal Charter or Scheme of the Commission.

Income and income funds means all incoming resources that become available to a charity and that the trustees are legally required to spend in furtherance of its charitable purposes within a reasonable time of receipt. Income funds may be unrestricted or restricted to a particular purpose of the charity.

Material or materiality: A material fund is one which the trustees or their auditor or independent examiner judge to be of such importance that its omission or misstatement would affect the reader's understanding of the accounts. Materiality depends on the size, amount or importance of the fund in relation to the total unrestricted and restricted funds managed by the trustees.

Permanent endowment is property of the charity (including land, buildings, cash or investments) that the trustees may not spend as if it were income. It must be held permanently, sometimes to be used furthering the charity's purposes, sometimes to produce an income for the charity. The trustees cannot normally spend permanent endowment without our authority. The terms of the endowment may permit assets within the fund to be sold and reinvested, or may provide that some or all of the assets are retained indefinitely (for example, in the form of a particular building).

Programme related or social investment is not 'investment' in the conventional sense of a financial investment. Conventional investments involve the acquisition of an asset with the sole aim of financial return which will be applied to the charity's objects. Programme related or social investments, by contrast, are made directly in pursuit of the organisation's charitable purposes. Although they can generate some financial return, the primary motivation for making them is not financial but the actual furtherance of the charity's objects.

Regulations refer to the Charities (Accounts and Reports) Regulations 2008 (SI 2008 No. 629) which set out the required form and content of the trustees' annual report and the scrutiny and accounting arrangements for charities. These Regulations apply to the annual reports of charitable companies incorporated under company law and non-company charities for accounting periods beginning on or after 1 April 2008.

Restricted funds: 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 spent at the discretion of the trustees in furtherance of some particular aspect(s) of the objects of the charity, or they may be endowment funds, where the assets are required to be invested, or retained for actual use, rather than spent.

Risk is used in this guidance to describe the uncertainty surrounding events and their outcomes that may have a significant financial impact. Risk may either enhance or inhibit any area of a charity's operations.

Statutory audit: Where the term statutory audit is used this refers to the requirement in charity law for an audit to be carried out where the charity's gross income and/or assets exceed the relevant threshold. An audit must be undertaken by a person who is eligible for appointment as auditor of a company, or a person approved by the Commission in accordance with the Regulations.

Subsidiary trading company is any non-charitable trading company owned by a charity or charities to carry on a trade on behalf of the charity or charities.

Trustee means a charity trustee. Charity trustees are the people who are responsible for the general control and management of the administration of the charity. In the charity's governing document they may be collectively called trustees, the trustee board, managing trustees, the management committee, governors or directors, or they may be referred to by some other title.

Unrestricted funds (including designated funds): Unrestricted income funds are income or income funds which can be spent at the discretion of the trustees in furtherance of any of the charity's objects. If part of an unrestricted income 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 spend the fund.

B. Key points about charity reserves

This section summarises the main points for charity trustees when considering reserves and when setting or reporting on their charity's reserves policy. This guidance is based on the requirements of charity law, the Charities SORP and good practice. In particular:

  • Charity law requires any income received by a charity to be spent within a reasonable period of receipt. Trustees should be able to justify the holding of income as reserves.
  • Reserves are that part of a charity's unrestricted income funds that is freely available to spend.
  • Where the trustees have a reserves policy, this policy must be set out in the trustees' annual report.
  • If the trustees have not set a reserves policy, this should be stated in the trustees' annual report.
  • A good reserves policy takes into account the charity's financial circumstances and other relevant factors.
  • It is good practice to monitor the level of reserves held throughout the year.
  • It is good practice to keep the reserves policy under review to ensure it meets a charity's changing needs and circumstances.

C. Understanding reserves and the need for a reserves policy

C1. What are reserves?

The short answer

Reserves are that part of a charity's unrestricted funds that is freely available to spend on any of the charity's purposes. This definition excludes restricted income funds and endowment funds, although holding such funds may influence a charity's reserves policy. Reserves will also normally exclude tangible fixed assets held for the charity's use and amounts designated for essential future spending.

In more detail

The Charities SORP defines reserves as that part of a charity's income funds that is freely available to spend. Reserves therefore exclude endowment or restricted income funds which have particular restrictions on how the funds may be used. Trustees need to consider how the funds of the charity are held and how they are being used in order to identify those resources that are freely available to spend.

Unrestricted funds

The starting point for calculating the amount of reserves held will normally be the amount of unrestricted funds held by a charity. However, part of the unrestricted funds of a charity may not always be readily available for spending. Examples of this are:

  • Tangible fixed assets: the Charities SORP specifically allows funds held as tangible fixed assets for charity use to be excluded from reserves. This recognises that certain assets will be used operationally and their disposal may adversely impact on a charity's ability to deliver its aims.
  • Programme-related investments: where a charity makes programme- related investments solely to further its charitable purposes, then such investments can be excluded from reserves.
  • Designated funds: where unrestricted funds are earmarked or designated for essential future spending, for example, to fund a project that could not be met from future income alone they can be excluded from reserves. In such cases the reserves policy should explain the nature and amount of the designation and when the funds set aside are likely to be spent. It is never acceptable to set up designations simply to reduce the stated level of reserves.

Restricted funds

Restricted funds fall outside the definition of reserves, but the nature and amount of such funds may impact on a charity's reserves policy. Where significant amounts are held as restricted funds the nature of the restriction should be considered, as such funds may reduce the need for reserves in particular areas of the charity's work. These factors and their potential impact on the reserves policy are explained in Annex 2 of this guidance.

Reserves held by subsidiaries

A charity may carry out activities through one or more trading subsidiaries and, in such cases, group or consolidated accounts may be required. Group accounts show the activities and resources of the charity and its subsidiaries. Where group accounts are prepared, the annual report will provide a narrative of the group's activities. In particular, the amount of reserves stated must take account of the net assets of subsidiaries.

C2. Why is a reserves policy important?

Short answer

A reserves policy explains to existing and potential funders, donors and other stakeholders why a charity is holding a particular amount of reserves. A good reserves policy gives confidence to stakeholders that the charity's finances are being managed and can also provide an indicator of future funding needs.

The Charities SORP requires a statement of a charity's reserves policy within its annual report. In addition, if a charity operates without a reserves policy, the Regulations require this fact to be stated in the annual report.

In more detail

Deciding the level of reserves that a charity needs to hold is an important part of financial management and forward financial planning. Reserves levels which are higher than necessary may tie up money unnecessarily. Holding excessive reserves can unnecessarily limit the amount spent on charitable activities, reducing the potential benefits a charity can provide. However, if reserves are too low then the charity's solvency and its future activities can be put at risk.

All charities need to develop a policy on reserves which establishes a level of reserves that is right for the charity and clearly explains to its stakeholders why holding these reserves is necessary.

A reserves policy provides essential accountability to funders, donors and other stakeholders. A good reserves policy will explain how reserves are used to manage uncertainty and, if reserves are held to fund future purchases or activities, it will explain how and when the reserves will be spent. A reserves policy provides assurance that the finances of the charity are actively managed and its activities are sustainable. In particular, a reserves policy can help to:

  • give confidence to funders by demonstrating good stewardship and financial management;
  • demonstrate the charity's sustainability and capacity to manage unforeseen financial difficulties;
  • give voluntary funders, such as grant-makers, an understanding of why funding is needed to undertake a particular project or activity;
  • give assurance to lenders and creditors that the charity can meet its financial commitments; and
  • manage the risk to a charity's reputation from holding substantial unspent funds at the year-end without explanation.

Developing a reserves policy is also an important part of the internal financial management of a charity. Developing a reserves policy is likely to:

  • Assist in strategic planning, for example, considering how new projects or activities will be funded.
  • Inform the budget process, for example, is it a balanced budget or do reserves need to be drawn down or built up?
  • Inform the budget and risk management process by identifying any uncertainty in future income streams.

We recommend that charities develop their reserves policy in an integrated manner, recognising that strategic and financial planning informs the development of reserves policies and vice versa. For example, the budgets will identify peaks and troughs in cash flow and the reserves policy will need to ensure the troughs in funding can be met from reserves held.

C3. How should a reserves policy be developed?

Short answer

Trustees need to understand the nature of any restrictions on the use of the charity's funds they hold. Budgets and future plans need to be considered, in particular any uncertainty over future income or the risk of unexpected calls on the charity's funds. In looking at future plans, projects or other spending needs might be identified that cannot be met from the income of a single year's budget alone. The identification of these factors might point to a need for reserves.

Having identified why reserves might be needed, trustees then need to think about how much might be required and how much is currently held as reserves. The decision made on these matters and the quantification of the amounts that need to be set aside forms a charity's reserves policy.

In more detail

There is no single method or approach to setting a reserves policy. The approach adopted will vary with the size, the nature and complexity of activities and the nature of funds received and held by a charity. However, for all charities, setting a reserves policy will involve:

  • Consideration of the nature of the funds received and held by the charity - are the funds unrestricted or restricted income, or expendable or permanent endowment? This understanding allows trustees to identify unrestricted funds which can be spent on any purposes of the charity.
  • Larger charities are likely to have a formal risk management process. But all charities need to think about uncertainties they may face in the future and the need to hold some reserves to meet an unexpected call on funds or opportunities that may present themselves.
  • Larger charities are likely to have strategic and operational plans. But all charities need to think about their future budgets and future projects or spending plans that cannot be met from the income of a single year.

By working through these steps the trustees will be well placed to identify why reserves might need to be held and to quantify the amounts of reserves needed to operate effectively.

Once a reserves policy is set, it should not be regarded as a static policy. The circumstances of a charity will change with time and we recommend that the policy should be reviewed at least annually as part of a charity's planning processes. The amount held in reserves should also be monitored during the course of the year as part of a charity's budgetary processes.

Annex 1 of this guidance sets an approach to setting a reserves policy that can be used by smaller charities which do not hold significant amounts of endowed funds, property or operate a defined benefit pension scheme or carry out activities through trading subsidiaries.

Annex 2 of this guidance sets out an integrated approach for larger charities with more complex activities and structures. An integrated approach to setting a reserves policy will see the development of a reserves policy as a product of strategic and operational planning and budgetary processes.

C4. What level or range of reserves is required?

Short answer

There is no single level or even a range of reserves that is right for all charities. Any target set by trustees for the level of reserves to be held should reflect the particular circumstances of the individual charity. To do this, trustees need to know why the charity should hold reserves and, having identified those needs, the trustees should consider how much should be held to meet them.

In more detail

The charity's target level of reserves can be expressed as a target figure or a target range and should be informed by:

  • its forecasts for levels of income for the current and future years, taking into account the reliability of each source of income and the prospects for developing new income sources;
  • its forecasts for expenditure for the current and future years on the basis of planned activity;
  • its analysis of any future needs, opportunities, commitments or risks, where future income alone is unlikely to be able to meet anticipated costs; and
  • its assessment, on the best evidence reasonably available, of the likelihood of each of those needs that justify having reserves arising and the potential consequences for the charity of not being able to meet them.

Trustees who hold reserves without attempting to relate their need for reserves to factors such as these will have difficulty in satisfactorily explaining why they hold the amount of reserves that they do.

C5. What steps should trustees take to maintain and monitor reserves at the target level?

Short answer

Reserves are held to help the charity operate effectively. Trustees should keep their reserves policy and the level of reserves held under review. Trustees should also monitor the level of reserves held throughout the year. In this way trustees will be aware of the build up of excess reserves or of reserves being unexpectedly or rapidly depleted.

In more detail

Having set the reserves level or range in which it is desirable to operate, it is important to monitor the reserves actually held to establish the reason for any significant difference with the target level set. If reserves during the year are below target or exceed target, the trustees should consider whether this is due to a short-term situation or a longer-term issue. Action may be needed to replenish or spend reserves.

The trustees' monitoring of reserves should not just be a year-end procedure. How the level of reserves changes during the year can be a good indicator of the underlying financial health of the charity and can be an indicator of potential problems. The level of reserves should be monitored throughout the year as part of the normal monitoring and budgetary reporting processes.

In particular, trustees should:

  • identify when reserves are drawn on so that they understand the reasons and can consider the corrective action, if any, that needs to be taken;
  • identify when reserve levels rise significantly above target so that they understand the reasons and can consider the corrective action, if any, that needs to be taken;
  • identify where the reserves level is below target, consider whether this is due to short-term circumstance or longer term reasons which might trigger a broader review of finances and reserves;
  • regard the ongoing review of the reserves level, target and policy as part of managing the charity;
  • ensure that the reserves policy continues to be relevant as the charity develops or changes its strategy and activities;
  • review the statement on reserves in the trustees' annual report where there have been significant changes in the reserves policy or level of reserves held.

Charities with very low or no reserves which face financial difficulty should also read our guidance Managing financial difficulties and insolvency in charities (CC12).

D. Explaining reserves in the annual report

D1. Must we explain our reserves in our annual report?

L symbol

Short answer

Yes, the Charities SORP requires all charities preparing accruals-based accounts, other than those charities following a more specialist SORP, to set out their reserves policy in their annual report. The Regulations also require a charity that does not have a reserves policy to state this fact in their annual report.

In more detail

The Charities SORP requires trustees to include in their annual report:

  • a statement of their policy on reserves;
  • the level of reserves held and an explanation of why they are held;
  • where material funds have been designated, the amount and the purpose of the designation should be explained;
  • where designated funds are set aside for future expenditure, the likely timing of that expenditure.

These requirements of the Charities SORP are given legal force by the Regulations which also require a statement in the event of a charity not having a reserves policy.

Our guidance publication Charity Reporting and Accounting - the essentials April 2009 (CC15b) provides a helpful checklist of the content of an annual report.

D2. What happens if our charity has no need of reserves or has excess reserves?

Short answer

It would be unusual for a charity, of any size, to operate without any reserves. However, if trustees conclude that the charity can prudently carry out its planned activities without reserves then this should be explained in their annual report. If a charity has excess reserves then trustees should consider how these funds might be effectively used in the future. If the resources are more than it could reasonably use to fulfil all of its purposes then the trustees should contact us to discuss whether the purposes of the charity should be amended to enable the charity to operate more effectively.

In more detail

Reasons for not having reserves

Whilst it would be unusual for a charity to choose to operate without any reserves, our earlier study, Small charities and reserves (RS5),found that in some cases trustees deliberately chose to hold no reserves. Some trustees budgeted to spend all the income received each year on the charity's activities.

Such a policy can create financial risk from the possibility of unforeseen expenditure, a shortfall in income or an inability to control costs. Trustees choosing to adopt a 'zero level' reserves policy should consider the financial and other risks inherent in such a policy and must explain their policy in the Trustees' Annual Report.

Charities with more resources than they need

A charity with excess reserves should consider whether these funds could be effectively spent on the charity's purposes. If a charity has more resources than it needs to fulfil all of its purposes then the trustees should contact us to discuss whether the purposes of the charity should be amended to enable the charity to operate more effectively.

E. Other questions about reserves

E1. Can a charity invest its reserves?

Short answer

Yes, reserves can be invested. However, by their nature, reserves tend to be resources that may be needed in the short- to medium-term. Trustees therefore should ensure that reserves are invested in a way can be readily realised as cash, when needed.

In more detail

When significant resources are held in reserves from year to year, the trustees should consider whether some or all of the reserves can be invested to obtain a financial return for the charity. In making the investment decision, the trustees should consider when the reserves might be needed (liquidity of the investment) and the acceptable level of investment risk.

The investment policy adopted will need to reflect the trustees' assessment of the likelihood that some or all of the reserves held may need to be accessed at short notice. Certain investments are more appropriate as long-term holdings and may be unsuitable or too high risk when it is known that a specific amount of cash will be needed in the short-term or at short notice to meet urgent need.

For charities with small sums to invest their investment policy for reserves may be very straightforward, such as holding any surplus funds with a UK bank or building society in an interest bearing account linked to the charity's current account with the provision for same-day money transfer.

Where the amount of reserves held is large and the trustees decide to invest all or part of those reserves in a wider range of investments than simply on deposit, then a more detailed analysis of why the reserves are held and how quickly those reserves may need to be accessed may be required. This should involve a more detailed consideration of the risks for which the reserves may be needed and the time frame in which cash might be required. Investing reserves in assets other than cash also involves a greater degree of investment risk. For example, investing in shares and corporate bonds offers the potential of a higher investment return but also carries a greater risk of loss.

Charities subject to statutory audit are required by the Charities SORP and the Regulations to set out their investment policy, including their investment objectives and the performance of the investments against those objectives in the trustees' annual report. This requirement also applies to invested reserves.

For further advice on investments refer to our guidance Charities and Investment Matters: A guide for trustees (CC14) - more detailed guidance is also available on our website for those that require it.

E2. What is the legal basis for holding and reporting reserves?

L symbol

Short answer

Trustees of every charity must ensure that the charity's funds are used appropriately, prudently, lawfully and in accordance with the charity's purposes for the public benefit. The general principle of trust law is that funds received as income should be spent within a reasonable period of receipt. The holding of reserves will be authorised either by using an express or implied power to hold reserves. 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.

In more detail

Charity trustees have a general legal duty to spend income within a reasonable time of receipt. Trustees may spend this income to fund charitable activities, in acquiring assets to use in the charity's work, and in meeting the day to day running costs of the charity. To hold income in reserve rather than spending it, trustees rely on an explicit or implicit power to hold reserves and they must use that power in the charity's best interests.

The charity's governing document may, in some cases, explicitly give the trustees an express legal power to hold income in reserve instead of spending it promptly. This power is not common but it is still worth checking the governing document in case there is such an express power to hold reserves.

The more common situation is that trustees will have to rely on their implied power to hold reserves. An implied power will not be written into the governing document but is a power implicit in trustees' duties enabling them to take actions which are necessary for the charity to function properly. Trustees are justified in exercising their power to hold income reserves, whether express or implied, only if in their considered view it is necessary to do so in the charity's best interests.

The power to hold reserves needs to be used appropriately by trustees. If the power is used without justification then the holding of income in reserve might amount to a breach of trust. A failure to report on the reserves policy adopted can indicate that trustees have not exercised their legal power correctly. However, good reporting of a charity's reserves policy can help to demonstrate the legal power to hold reserves has been properly used.

E3. Can trustees accumulate income funds?

L symbol

Short answer

A power to accumulate income by adding income to the capital of an endowment fund should not be confused with holding income as reserves. A small number of charities have a power in their governing document to add income of the charity to capital of an endowment fund. Income cannot be accumulated in this way unless the trustees have an express power that allows them to do so.

In more detail

On occasions, some charities inappropriately add income to the capital of their endowment funds. On other occasions, some charities have, over a number of years, inappropriately invested income to build up a fund which is regarded by the trustees, for all practical terms, as an endowed fund unavailable for spending. These practices are unacceptable unless there is an express power to accumulate.

If trustees want to accumulate income they should check their governing document to see if there is a power of accumulation which allows trustees to convert income into endowment. Converting income into endowment takes the converted resource outside the scope of reserves (since the definition of reserves does not include any endowment funds).

Even if trustees have a power to do so, trustees can only accumulate for a maximum period of 21 years from the first day when the income can be accumulated or, where the governing document so provides, for the period up to the death of the settler (section 14 of the Perpetuities and Accumulations Act 2009 which came into force on 1 April 2010). It is possible for the court or the Commission to authorise accumulation for a period longer than the statutory maximum in appropriate circumstances.

If funds are accumulated without a power to convert them to endowment then they continue to be income funds. Such accumulated unrestricted income funds count as reserves and must be reported as such in the annual report.

In some circumstances there may be doubt as to whether a donation or legacy is a gift of income or endowment funds. 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 trustees must treat the gift or legacy accordingly. If there is no evidence to the contrary the donation must be treated as income and used in a way that is consistent with any terms of the gift and the charity's governing document.

E4. What are the tax issues involved in holding reserves?

Short answer

The justifiable retention of reserves should not have any adverse tax implications.

In more detail

Much of the income received by charities is exempt from Income Tax and Corporation Tax provided that the money is used for charitable purposes only. HM Revenue & 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.

Tax exemption is not available if either:

  • the income has been invested in an investment which is not a "qualifying investment" (within the meaning of Schedule 20 of the Income and Corporation Taxes Act 1988). Investments made for the benefit of a charity and not for the avoidance of tax are likely to count as qualifying investments, but trustees in any doubt whether or not an investment is a qualifying investment will need to take advice; or
  • the income is retained by the charity without being placed on deposit or otherwise invested for an excessive period.

Trustees should refer to the HM Revenue & Customs website for further information on income tax and corporation tax exemptions and reliefs for charities particularly if the charity or its subsidiaries undertake non-charitable trading activities.

E5. Can charities fundraise and apply for grants or contracts if they have reserves?

Short answer

Yes. It is important when fundraising that trustees maintain the confidence of the public in their charity by being open and transparent about their charity's need for funds. If the charity has excess reserves, the trustees should ensure that they do not misrepresent the urgency or need for funds.

When a charity is applying for a grant or is bidding for a contract, it is important that the funder understands the charity's reserves policy and that the policy explains and justifies the reserves held.

In more detail

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.

If a charity is widely believed to have large reserves, further appeals for funds may provoke resentment against the charity for apparently seeking funds it does not need. In wording its appeals, and in dealing with any reaction to the appeals, trustees should take care not to give anyone the wrong impression about the extent or urgency of their charity's need for funds.

Some charities can have difficulties with the way their reserves are viewed by funders. If the reserves appear too large, there may be an assumption that the charity does not have a need for additional funds. If the reserves appear too low, there could be a refusal to fund on the basis that the charity's finances are unstable and the charity may be at risk of financial difficulty or insolvency.

Trustees should ensure that they can explain their reserves policy to funders by showing that:

  • the reserves held are based on a policy and a clear understanding of what the money is to be used for;
  • the charity is operating with sufficient reserves to avoid financial difficulties;
  • reserves are an essential element of strategic planning; and
  • the charity is being open to their stakeholders about the level of reserves.

Where trustees are seeking grants or contracts from funders they should ensure that they:

  • understand the funder's policy towards applicants' reserves;
  • seek opportunities to explain to the funder their charity's reserves policy and reasons for the level of reserves held; and
  • present the charity's reserves policy and reserves level in a positive way that is understood.

F. Further information

F1. Other Commission publications

Our website offers a wide range of easily accessible online services, tools, information and guidance. Before contacting us for advice or help you might like to search our online database of frequently asked questions. Most people can find the answer they need without making a phone call or writing an email. Alternatively, our Contacting us page is linked to from the top and bottom of every webpage.

For further information you may find it useful to refer to the following Charity Commission publications:

Managing financial difficulties and insolvency in charities (CC12)

Charities and Investment Matters: A guide for trustees (CC14)

Charity Reporting and Accounting: The essentials April 2009 (CC15b)

Charities and Risk Management: A guide for trustees (CC26)

Changing your charity's governing document (CC36)

Schemes (OG500)

Small Charities and Reserves (RS5)

Charity reserves and defined pension schemes

F2. Other sources of information

The SORP is available as a free PDF download, but you can also buy a printed copy:

F3. External organisations

Charity Finance Group (CFG)
Charity Finance Group is a membership charity specialising in helping charities manage their accounting, taxation, audit and other finance related functions. CFG publish a range of Made Simple Guides including 'reserves policies made simple' which provides another perspective on developing a reserves policy.

Charity Finance Group
CAN Mezzanine
49-51 East Road
London
N1 6AH

Tel: 0845 345 3192
Website: www.cfg.org.uk

HM Revenue and Customs
HMRC is the department responsible for collecting and administering certain taxes. It provides information on a wide range of issues including tax issues relating to charities.

Telephone: 0845 302 0203 (a helpline for charities)
Website: www.hmrc.gov.uk

The National Council for Voluntary Organisations (NCVO)
The NCVO is a national charity that provides support and a wide range of information for voluntary and community organisations. Its website offers advice on various issues connected with risk management in the third sector.

Included within Advice and Support is an NCVO guide called 'Reserves policy for smaller organisations'.

NCVO
Regent's Wharf
8 All Saints Street
London
N1 9RL

Tel: 020 7713 6161
Website: www.ncvo-vol.org.uk

Wales Council for Voluntary Action (WCVA)
The voice of the voluntary sector in Wales. It represents the interests of, and campaigns for, voluntary organisations, volunteers and communities in Wales. WCVA provides a comprehensive range of information, consultancy, funding, management and training services. Charities can use the WCVA website to find their nearest County Voluntary Council (CVC).

WCVA produces Information Sheets to help trustees. The Information Sheet called 'managing money' includes a section on reserves.

Wales Council for Voluntary Action
Baltic House
Mount Stuart Square
Cardiff Bay
Cardiff
CF10 5FH

Helpline: 0800 2888 329
Website: www.wcva.org.uk

Annex 1: A simple approach to developing a reserves policy

The following three questions are designed to help guide trustees of smaller charities through the issues that need to be considered when developing their reserves policy. Trustees managing charities with more complex activities or structures may find that this approach does not go into enough detail and should look at the guidance given in Annex 2 instead.

Question 1. Why might you need reserves for the charity to be effective?

The basis of a good reserves policy is thinking through exactly why you might need to hold back some funds as reserves. In a small charity, with a simple structure and uncomplicated activities, the reasons might include:

a) The risk of unforeseen emergency or other unexpected need for funds, eg an unexpected large repair bill or finding 'seed-funding' for an urgent project.

b) Covering unforeseen day-to-day operational costs, eg employing temporary staff to cover a long-term sick absence.

c) A source of income, eg a grant, not being renewed. Funds might be needed to give the trustees time to take action if income falls below expectations.

d) Planned commitments, or designations, that cannot be met by future income alone, eg plans for a major asset purchase or to a significant project that requires the charity to provide 'matched funding'.

e) The need to fund short-term deficits in a cash budget, eg money may need to be spent before a funding grant is received.

If, after considering the above, you think that reserves are needed please go to question 2. If you conclude that your charity does not need to hold any reserves, then you must explain that in your annual report.

Question 2. How much do you need in reserve?

The reserves level may be a target amount or a target range. For example, for each reason set out in question 1:

a) An amount might be needed to meet an unforeseen emergency or other unexpected need - consider risks and how much might be needed for such contingencies; this will involve judgement of events that may occur and their likelihood.

b) Look at your expenditure budget - do you need a small contingency fund to meet unforeseen operational costs?

c) Uncertainty over future income might mean having reserves equivalent to a number of weeks of income equivalent to a range of £x to £y, to allow time to develop new sources of income or to cut-back on related expenditure.

d) A planned spending commitment which cannot be met from future income would imply a need for a specific sum to be set aside - often this amount will be included within designations in accounts.

e) An amount might be needed to cover 'troughs' in the cash budget - review budgets to ascertain how much might be needed.

In summary, the financial risks you identify should influence the amount of reserves you target to hold and be explained in your reserves policy.

Question 3. Have you got any funds in reserve at the end of the year?

The final step is to compare what you might need in reserve with what you actually hold. You should:

  • Calculate the amount of any reserves according to the definition of reserves given in section C1 of the guidance.
  • State the amount of reserves held and compare with the target amount or target range set for reserves.
  • Explain any shortfall or excess in reserves against target set.
  • Explain any action being taken or planned to bring reserves into line with your target.

Where the difference is small, no action may be needed.

Information about the reserves policy and the level of reserves held must be included in the Trustees' Annual Report.

Annex 2: An integrated approach to developing a reserves policy for a charity with more complex activities and structures

Trustees of charities with more complex activities and structures need to take into account a broader range of factors when developing their reserves policy. These charities will be undertaking a greater range of activities or be funding a scale of operations much greater than that of charities with simpler affairs. For example they may be undertaking primary purpose trading or providing goods or services under contract. They are likely to hold a number of restricted funds, employ staff and may own buildings or operate trading subsidiaries.

Setting a reserves policy is not a task undertaken in isolation. A reserves policy is a product of a charity's strategic planning, budgeting and risk management processes. These processes provide trustees with the information they need to establish exactly why they might need reserves and to help them quantify that need. The steps involved in these processes are interrelated with the outcome of one process informing another. For example, identified financial risks will inform both budgeting and the reserves policy. Setting a reserves policy can be approached in different ways. This annex presents one approach and is set out as steps in a process, but it is important to remember each of these steps is connected.

Step 1 - Understanding the nature of charitable funds held;
Step 2 - Identifying functional assets;
Step 3 - Understanding the financial impact of risk;
Step 4 - Reviewing sources of income;
Step 5 - Impact of future plans and commitments;
Step 6 - Agreeing a reserves policy.

When taking each of these steps, trustees should reflect on the guidance and think through how it applies in the circumstances of their own charity. From this they can develop their reserves policy. Not every factor will apply to every charity. Similarly, some factors may have a greater influence than others in shaping the trustees' thinking in developing their reserves policy.

Step 1 Understanding the nature of charitable funds held

Reserves are that part of a charity's unrestricted income fund that is freely available to spend on any of the charity's purposes. To set a reserves policy, it is vital for trustees to understand any restrictions on the use of the charity's funds. In certain circumstances holding restricted funds may reduce the need to hold reserves for particular purposes.

Restricted funds can only be used for particular purposes of a charity that are narrower than the overall charitable purposes of the charity. Restricted funds include endowments and restricted income funds are excluded from the definition of reserves. However, the nature and amount of restricted funds may influence the amount of reserves held by a charity.

For example, an overseas aid charity may operate on a worldwide basis but have a restricted income fund for the area of Asia. A restricted income fund for Asia, which is not otherwise limited in its use, means that any of the activities and programmes in Asia can be funded from that restricted income fund. This flexibility can reduce or remove the need for the charity to hold unrestricted funds in reserve for its activities in Asia.

Expendable endowment is excluded from the definition of reserves. Nevertheless, expendable endowment offers trustees considerable flexibility in how they may use the funds, and this may influence the amount of reserves trustees choose to hold. Expendable endowment, when invested, can provide a relatively secure stream of income but the trustees also have the option of spending all, or part, of the endowment. This freedom may reduce the need for reserves, especially where the charity is not wholly dependent upon the investment income provided by the expendable endowment to fund its activities.

However, where charities with an expendable endowment depend on the investment income to fund core or continuing activities, then the need for reserves may be greater. Trustees are less likely to be willing to spend the expendable endowment if this will reduce the income available to fund future activities.

A permanently endowed fund cannot be spent as income and so the capital is invested to produce income for the charity. If the terms of the permanent endowment do not restrict its use then the income is unrestricted and can be spent on any of the purposes of the charity. The relative security of the investment income from an endowment fund will be a factor that may influence the need for reserves. The Charities Act also introduced amendments which give many charities greater flexibility to spend some or all of their permanent endowment in certain circumstances.

A total return approach to investment allows trustees greater flexibility in how investment returns can be allocated to income funds. The Charity Commission is able to make an order that permits the investment of permanent endowment on a total return basis. Total return is an investment management approach which considers the overall return from the investment, both capital gains (and losses) and any income. The trustees then decide how much of the total unapplied return can be allocated to income and how much is retained for future spending. In making this decision, the trustees must consider the needs of current and future beneficiaries.

The flexibility of the total return approach can enable charities with significant permanently endowed funds to a hold a lower level of reserves than similar charities without such a power. Total return gives trustees the flexibility to spend funds held as part of the unapplied total return when needed and so can reduce the need for reserves.

Step 2 Identifying functional assets

The identification of unrestricted funds is a vital initial stage in the development of a reserves policy. However, certain functional assets used operationally by a charity might be essential to the implementation of their operational strategy. The Charities SORP specifically allows funds held as tangible fixed assets for charity use to be excluded from reserves. This recognises that certain assets will be used operationally and their disposal may adversely impact on a charity's ability to deliver its aims.

Where the trustees consider functional fixed assets to be essential to the delivery of the charity's aims then the value of such assets can be designated and excluded from the calculation of reserves. However, it is important for trustees to ask why particular fixed assets are held. For example, could a high value administrative office be sold and rented accommodation used if funds were needed? Some trustees might regard such an asset as part of their reserves which could be realised, if necessary, to support their operational work. This situation might, for example, be contrasted with a care facility where its sale might interrupt the care of beneficiaries and obtaining alternative specialist facilities on a rental basis might prove difficult.

Similarly, where a charity makes programme related investments solely to further its charitable purposes then such investments can be excluded from reserves.

Step 3 Understanding the financial impact of risk

Identifying and managing risk is an important part of good charity governance. Certain risks, if they occur, will have a financial impact and will be considered as part of the budgetary process. Identified financial risk will also influence and inform a charity's reserves policy. Holding reserves may form part of the charity's strategy for managing the impact of an identified risk should it occur.

The Charity Commission's guidance Charities and Risk Management: A guide for trustees (CC26) identifies the key risks which most charities should consider. Whilst risk is broader than just financial risk, in working through the guidance on risk management, trustees should consider the financial impact on the charity of the identified occurring and ask whether reserves are needed to help manage the financial impact.

Charities should be responsive to beneficiary needs and for some charities this can arise urgently and unexpectedly. Again, charities should consider the need to hold reserves in response to such events or whether it can rely on an appeal to the public where urgent need arises.

Step 4 Reviewing sources of income

The stability of future income is a key factor in the financial health of a charity. The assessment of the stability and certainty of future income sources will form an important part of a charity's assessment of risk and will feed into both budget setting and reserves policy. Some of the issues trustees should consider include, whether:

  • the charity's income is from a single or multiple sources;
  • the charity is particularly vulnerable should there be a sudden or unforeseen decline in a particular source of income;
  • the charity relies on a single contract or grant for a significant part of its funding which is subject to tender or review in the near future;
  • any major donor has indicated a change in their planned giving;
  • appeals or fundraising activities provide a stable funding source;
  • certain sources of income are particularly vulnerable to the general economic situation.

In reviewing the stability of income, trustees should consider:

  • how much notice of a change in income would the charity get;
  • the key dates at which major contracts or grants are due for review or renewal;
  • the impact of any other organisations seeking funding from the same sources;
  • the strength of the charity's relationships and communications with its donors and financial supporters about explaining its financial needs.

If a charity has stable or predictable income this may reduce the need for reserves. Alternatively, if a charity's income is volatile or insecure, or is vulnerable to factors outside of its own control, this may justify holding more reserves. Trustees should also consider if the charity's reserves are sufficient to protect it from the risk of insolvency or serious disruption to its charitable work.

Step 5 Impact of future plans and commitments

When setting the operational plan for the year, trustees will have considered how that plan will further the charity's aims for public benefit. The operational plan brings together the activities that the charity will undertake with the resources at its disposal.

Usually the operational plan is then expressed in financial terms as a budget with the expected income identified by source and the expected costs identified by planned activity. In setting a budget, consideration will need to be given to any restriction on the use of particular funds and uncertainty associated with predicting future income. The cash budget will help identify peaks and troughs in the charity's cash flow and will give a warning of when reserves might need to be called on.

Commitments and designations

Commitments made in previous and current financial years will also impact on cash budgets. For example, where commitments have been made to pay grants over a number of years then reserves may need to be built up to meet these costs if future income streams are uncertain.

As part of a charity's strategic planning, the trustees will also look beyond the annual operational plan and annual budget. This will be particularly important in identifying projects or capital spending plans that cannot be met from anticipated future income alone. Where planned expenditure cannot be met from a single year's income alone then this may point to the need to build up reserves to meet future expenditure. If reserves are to be built up in this way, then budgets will need to reflect these plans.

Often the funds set aside to meet future commitments and plans will be held as designated funds. By identifying a need and setting funds aside in a designated fund, trustees can build up the funds needed over a period of time and help manage the financial risk of a project. In this way they spread the burden over several years. When calculating the amount of reserves stated in an annual report, trustees may exclude the amount properly designated from the reserves total. The amount and nature of the designations should be explained in the annual report as should the likely time of their expenditure.

Designations relate to future plans that exist at a point in time. The annual report explains the year end position of a charity and therefore no new designations can be set up retrospectively after the year end to disguise the true level of unrestricted funds held in reserve. Designations which are never used, or the nature of which are frequently changed without funds being spent, risk bringing the charity into disrepute with donors and financial supporters. If a complaint is made to the Charity Commission about a charity's reserves, the inappropriate use of designated funds may attract regulatory attention.

Defined benefit pension schemes

Where charities have employees who are entitled to defined benefit pensions (final salary pensions), there are particular issues that arise in relation to the obligations of the charity to the pension scheme which may affect the charity's reserves.

Where a charity operates, or is a member of, a defined benefit pension scheme, trustees should read our guidance Charity reserves and defined benefit pension schemes. The defined benefit pension scheme may be a multi-employer scheme or the charity's own scheme. Depending upon the balance of assets and liabilities within the scheme, the charity may have a pension asset or liability.

Where the pension asset or liability is material, the reserves policy statement should separately consider the impact on the charity's financial position and reserves. The cash flow implications of making good any pension liability will influence the reserves policy and the reporting of the reserves.

Where there is a pension asset, this is normally designated and not counted as part of the charity's reserves because it is not available to the charity's trustees to spend. Where there is a pension liability this may require some or all of the available unrestricted funds that are otherwise uncommitted to be designated to meet all or part of that liability. The decision on whether to designate funds to meet a pension liability will depend upon the charity's ability to finance that liability out of its current and future income.

Trustees should explain to the charity's stakeholders the impact on its reserves policy of a defined benefit pension scheme. Trustees should pay particular attention to explaining clearly and simply how the pensions accounting disclosures should be interpreted in the context of the charity's finances.

Step 6 Agreeing a reserves policy

After considering the issues described in steps 1 to 5 above the trustees can make an informed decision about holding reserves and the amount to be held. Where the trustees agree that reserves are needed these should be explained in the reserves policy along with a justification of the planned level of reserves and a statement of the reserves currently held. Trustees should also provide an explanation if the reserves held differ significantly from the target they have set for reserves.

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