OPERATIONAL GUIDANCE

CHARITY INCOME RESERVES

THE LAW AND OUR POLICY

OG 43 B2 - 11 January 2007

Divisional responsibility

For information:

Charity Support Division

Contents

1. The position in law
2. Our policy
3. Putting policy into practice
4. Satisfying public concern and scrutiny
5. Role of funders

Meaning of expressions - list of Glossary terms used in this Guidance
Index to further related information

1. The position in law

1.1 Duty to apply incoming resources
1.2 Power to hold reserves may be express or implied
1.3 Converting income into endowment (accumulation)
1.4 The corporate property of charitable companies
1.5 The total return approach to investment

In our view, it is well-established that:

• the incoming resources of a charitable trust should be applied as income unless the trusts attaching to them identify them as endowment/capital; and

• charity trustees are under a general legal duty to apply the income of their charity for its purposes within a reasonable period of receipt (subject to any valid provision in the charity's governing document which may authorise the conversion of income resources into endowment/capital).

It is recognised that a charity may need to retain some reserve of income in order to ensure the continued furtherance of its objects. This is reflected by the inclusion of the word "reasonable" in the phrase "within a reasonable period of receipt". But it is clearly not "reasonable" to retain income where there is no connection between doing so and ensuring the proper administration of the trust.

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 but, much more often, they will have to rely on their implied power to take actions which are necessary for the charity to function properly.

Whether their power is express or implied, trustees are justified in exercising it only if, in their considered view, it is necessary in the charity's best interests to do so. If it is done without justification, the holding of income in reserve may amount to a breach of trust

1.3 Converting income into endowment (accumulation)

A small number of charities have in their governing document a power to convert income into capital/endowment (that is, a power to accumulate). This is not the same as a power to hold income in reserve. Converting income into endowment takes the converted resource outside of the scope of reserves (since our definition of reserves does not include any endowment (capital) funds).

The exercise of an express power to accumulate should be the result of a conscious decision on the part of the charity trustees; such a power should, like any other power, be exercised only in the interests of the charity.

Sometimes charity trustees who do not have a power to accumulate may ask us to authorise them to do so, by Scheme, or by Order under s.26 of the 1993 Act. Before doing so we need to be satisfied that this would be expedient in the charity's interest.

Apart from situations where the power to accumulate is part of a total return approach to investment - see section 1.5, one example where it could be expedient to authorise accumulation is where a charity has received an exceptionally large dividend or other distribution from a company, which is technically "income" but in common sense appears to be a return of part of the capital investment. Trustees have a duty to maintain a fair balance between capital and income interests in a fund. It may upset this balance to insist that a distribution of this nature should, or should all, be treated as income - which has to be applied for the purposes of the charity within a reasonable period of receipt.

1.4 The corporate property of charitable companies

The principles outlined in section 1.1 above apply to trust property administered by all companies, whether charitable or not, but the corporate property of a charitable company is not held on trust.

Company law imposes no explicit duty on the directors of a charitable company to apply its corporate property within a reasonable time of its receipt but that does not sanction its indefinite aggregation. It is legitimate to expect that a charitable company's incoming resources should be used to further its objects - see section 3 of OG 43 P1 for a case where the legitimate expectations of the members of a trading company were recognised.

1.5 The total return approach to investment

When we authorise a charity to adopt a total return approach to investment - see OG 83 - this does not authorise trustees to convert income into capital (endowment). The return on the investment, in whatever form it is received, is treated for technical reasons as permanent endowment, unless and until the trustees allocate it to a trust for application (income). It must then be applied for the purposes of the charity within a reasonable period.

Adopting a total return approach will give trustees greater flexibility in the allocation of investment returns. But once any part of the investment return has been allocated to the trust for application (income) then it should only be retained in the trust for application (income) in accordance with a proper policy on the maintenance of reserves - see section 3. There is generally no need for trustees to build up reserves in the trust for application (income) to cover a year when the investment funds for that year are minimal or negative. This is because any part of a charity's unapplied total return may be allocated to the trust for application (income) at any time. However, when trustees utilise the flexibility under a total return approach they must act consistently with the underlying duty to be even-handed between the interests of current and future beneficiaries. Under-allocation to the trust for application (income) would prejudice the interests of current beneficiaries. Over-allocation to the trust for application (income) would prejudice the interests of future beneficiaries.

If trustees exercise their discretion to allocate investment return to the trust for application (income) or retain it on trust for investment (capital) in accordance with the principles set out in OG 83, this will be consistent with our policy in relation to establishing and justifying reserves.

2. Our policy

If a charity can demonstrate to donors and others that it has good reasons to retain a particular level of income as a reserve (that is, if it can justify its position) then we consider it is acting responsibly. A charity which has no reserves does not avoid the need for justification - "nil" is a level of reserves and a charity in this position needs to be clear that this is right in their circumstances and have a policy for the future.

Justifying reserves 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.

Our views on how this may be done are set out in paragraphs 34 to 43 of CC19. For ease of reference, this guidance is reproduced in sections 3.2 to 3.6 below.

Section 5 of OG 43 B1 explains where to look in a charity's accounts and annual report for a statement of its reserves policy and position. OG 43 C1 explains how to use this information to form a view as to whether or not the charity's policy and practice is in line with our recommendations.

3. Putting policy into practice

3.1 General approach
3.2 Justifying reserves
3.3 A reserves policy
3.4 Mismatched levels of reserves
3.5 Charities with small or no reserves
3.6 Realistic assessment of need for reserves

To justify their holding of reserves, trustees should have a reserves policy, but this cannot be formed in isolation. Trustees need to have an understanding of the whole of their charity's accounts and they need to draw on this knowledge and understanding to form and develop an appropriate reserves policy. The policy should take account of the charity's current and anticipated income and expenditure and of all of its other funds and assets. For instance, if money has already been earmarked for a particular contingency in a designated fund, it does not need to be covered again by reserves.

NB. We do not wish to overburden small charities, and you should not expect or require such a charity to produce a sophisticated reserves policy. The following general guidance from CC19 needs to be tailored to the size and complexity of the charity.

To justify their holding of reserves, trustees should have a reserves policy based on a realistic assessment of their reserves needs.

Apart from providing justification for trustees to exercise their legal power to hold reserves, many charities believe this process to be an essential part of good financial management practice.

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.

In some 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.

The policy should cover as a minimum:

• the reasons why the charity needs reserves (or does not need them);

• what level (or range) of reserves the trustees believe the charity needs;

• what steps the charity is going to take to establish or maintain reserves at the agreed level (or range);

• arrangements for monitoring and reviewing the policy.

It is stressed 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.

Generally, 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 these matters relatively quickly, and to record briefly the trustees' conclusions.

3.4 Mismatched levels of reserves

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.

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.

3.5 Charities with small or no reserves

Some charities will be able to justify holding a certain level of reserves but will be unable to build up reserves to that, 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 expect a charity to have a reserves policy even if it currently has no reserves.

Established charities with low reserves may have incorrectly designated funds or may be facing financial difficulties (see OG 43 A1). We would expect a reserves policy to make it clear that there are no financial difficulties (referring to the designated funds if these provide mitigation) or to stress that there are financial difficulties which the trustees are (or are not) addressing.

A conscious decision to hold no reserves of income does not mitigate against the need to have a reserves policy. "Nil" is a level of reserves which needs to be justified by the charity's circumstances.

3.6 Realistic assessment of need for reserves

A charity's reserves policy should be informed by:

• its forecasts for levels of income in future years (taking into account the reliability of each source of income, and the prospects for opening up new sources);

• its forecasts for expenditure in future years on the basis of planned activity;

• its analysis of any future needs, opportunities, contingencies or risks, the effects of which are not likely to be able to be met out of income if and when they arise;

• its assessment, on the best evidence reasonably available, of the likelihood of each of those needs, etc, arising, and the potential consequences for the charity of not being able to meet them.

Trustees who hold reserves without making any attempt to relate their need for reserves to factors such as these will probably have difficulty explaining in any convincing way why they hold reserves.

4. Satisfying public concern and scrutiny

Underlying much public discussion of charity reserves is the belief that holding reserves is tantamount to hoarding.

This belief is likely to persist unless charities justify and explain their reserves position. 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.

Any charity could find its reserves subject to scrutiny and comment in the public arena. Charities which:

• operate in areas where there is clear evidence of immediate human need; or

• rely on a strong emotive appeal involving vulnerable groups or animals; or

• are running public appeals emphasising the urgency of their own need for donated funds,

are likely to attract the most attention, especially if they hold sizeable sums as reserves.

Charities applying to statutory or voluntary funders are also likely to have their reserve levels closely assessed.

5. Role of funders

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 proper 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 might expose the charity to insolvency.

Generally speaking, we should encourage funders to apply the same kind of criteria in assessing reserve levels as we do ourselves: that is, on the basis of proper justification rather than the application of any arbitrary rule.

See OG 43 C2 if a charity asks us to intercede between it and a potential funder.

The following words and phrases are defined in the Glossary of Terms:

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1993 Act
charity trustees
designated funds
governing document
income funds
reserves
SORP / the Charities SORP
trustees

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