OG43 B2 - THE LAW AND OUR POLICY

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OPERATIONAL GUIDANCE

CHARITY INCOME RESERVES

THE LAW AND OUR POLICY

OG 43 B2 – 15 May 2009

Purpose

Functional responsibility

For action

Charity Services

For information

Contents

1. The position in law
2. Our regulatory stance on reserves
3. Putting policy into practice
4. Satisfying public concern and scrutiny
5. Role of funders
Glossary of Terms used in this Guidance

Index to further related information


The Law	Refer to a lawyer	Refer to an accountant

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 1.6 Defined benefit pension schemes and reserves

	1.1 Duty to apply incoming resources
	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).
	For precedents which support this view see sections 1 and 2 of OG 43 P1.
	It is recognised that trustees in the charity’s interest may need to retain some reserve of income to ensure the smooth and effective operation of the charity 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, to the detriment of beneficiaries which the charity should be assisting, where there is no connection between doing so and ensuring the proper administration of the trust.

	1.2 Power to hold reserves may be express or implied
	The governing documents of a small number of charities contain an express legal power 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 and may justify the use of our regulatory powers.

	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.
	An example of a special case is the power to accumulate as part of a total return approach to investment of permanent endowment (see section 1.5 )
	If you receive an application from a charity for authority to accumulate you should seek legal and accountancy advice at an early stage to ensure the case made is justified by the circumstances of the charity and takes proper account of its effect on both current and future beneficiaries.

	1.4 The corporate property of charitable companies
	The principles outlined in section 1.1 above apply to trust property administered by a charitable company or where a non-charitable company is a corporate trustee of a special trust or endowment.
	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 accumulation. 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 Endowed Charities: A total return approach to investment) This does not authorise trustees to convert income into capital (endowment). The return on the investment (gain or loss), 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). A gain is added to the unapplied total return and must then be applied for the purposes of the charity whereas a loss reduces the total unapplied return available for application.
	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 alternatively retain it on trust for investment (capital) in accordance with the principles set out in OG 83, this will be a justified use of their power. The reasonable exercise of their total return power is sufficient to justify any retained unapplied total return and is compatible with our policy in relation to establishing and justifying reserves.

	1.6 Defined benefit pension schemes and reserves
	Where accounts are prepared on the accruals basis, the Charities (Accounts and Reports) Regulations 2008 require these to be prepared in accordance with the methods and principles of the SORP on a true and fair basis. Accounting standards and the SORP require the balance sheet recognition of pension assets or liabilities relating to a defined benefit pension scheme. Further information on this can be found in our guidance note Charity Reserves and Defined Benefit Pension Schemes A defined pension asset is where the assets of the pension fund (or the charity’s share of them) exceeds the pension liabilities of that fund to current and future pensioners. More commonly with volatile world equity markets there is a reverse situation and a defined pension liability.
	We should refer to Charity Reserves and Defined Benefit Pension Schemes when considering the circumstances of a charity with a defined benefit pension scheme and its reserves. In short, pension schemes are long term obligations and whilst the existence of a pension asset or a pension liability will affect the reserves policy and the reserve balances held, when calculating the reserves, the pension asset or liability should be excluded from the reserves calculation.
	In handling a case involving a pension liability or asset, due to the complexity of pension arrangements and obligations, legal and accountancy advice should be taken at all stages of the case handling.

2. Our regulatory stance on reserves
	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’ or ‘negative’ shows that a decision has been taken regarding reserves and a charity in this position needs to be clear that this is right in the circumstances and it must 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 regulatory stance is: To encourage charities to have, maintain and review a reserves policy. To be proportionate and expect a brief statement of reserves for a small charity (below the audit threshold) which is consistent with an adequate explanation of the reserves held and reasons for holding reserves. We would expect greater detail and consideration from larger charities commensurate with the complexity and size of the charities involved. To encourage charities to disclose and explain their reserves in a transparent way. Not to become involved in third party disputes about reserves eg with funders, and instead expect charities to resolve disputes through dialogue with those who are challenging or complaining about their reserves. To expect charities to deal directly with those challenging or complaining about their reserves levels, before making any regulatory interventions, if required. To refer charities, in cases where their reserves are too low, to our guidance CC12 Managing Financial Difficulties and Insolvency in Charities.
	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 we apply a number of risk factors when assessing whether our regulatory intervention is required and how to use information from the annual report and accounts to carry out an assessment of the charity's policy and practice.

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

	3.1 General approach
	We expect charities to comply with their obligations and make such disclosures as required by SORP. This self regulatory approach allows: each charity to tell its story; trustees to explain how their plans for reserves have developed and changed; reserves held to be placed in context; stakeholders to have an informed view about a charity’s reserves. This self regulatory approach is proportionate and avoids the Commission imposing arbitrary norms, bands or targets which might distort trustee behaviour and impede good governance.
	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

	3.2 Justifying reserves
	To justify their holding of reserves, trustees should have a reserves policy based on a realistic assessment of their reserves needs. It should explain clearly to donors, financial supporters and other stakeholders why the reserves are needed. Where a charity decides to proactively reduce the level of its reserves, for example, to maintain its activities during an economic downturn, it should also explain this approach. Transparency and accountability are essential in maintaining public confidence and countering any impression of a charity hoarding funds.
	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 and this practice may justify our regulatory intervention.

	3.3 A reserves policy
	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); and
	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.

	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 accumulating income funds without justification. Those funds ought to be expended for charitable purposes. Other charities in the same field may have an urgent need for funds, or current beneficiaries could have outstanding needs that can be met. Retaining excessive reserves in such circumstances could be detrimental to the public benefit and may justify our regulatory intervention. 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 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 a reserve, we would still expect a charity to have a reserves policy even if it currently holds no reserves.
	Established charities with low reserves may have incorrectly designated funds or may be facing financial difficulties (see section 3 of OG 43 A1). Where reserves are low (nil or negative) we would expect a reserves policy to make it clear that there are no financial difficulties (referring to and explaining any designated funds where appropriate) 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 mean that a charity does not need a reserves policy. ‘Nil’ shows that a decision has been taken regarding reserves and this 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.
	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 section 3 of OG 43 C2 if a charity asks us to intercede between it and a potential funder.

Glossary of Terms used in this Guidance
	1993 Act
	charity trustees
	designated funds
	governing document
	income funds
	reserves
	SORP / the Charities SORP
	trustees

Index to further related information