OPERATIONAL GUIDANCE

CHARITY INCOME RESERVES

SCRUTINISING A CHARITY'S RESERVES POLICY

OG 43 C1 - 7 November 2000

Divisional responsibility

For action:

Charity Support Division
Charity Database Division

Contents

1. How cases may arise
2. General approach
3. Charitable companies
4. Initial action by Charity Support Division
5. Looking at fund balances not included in our definition of reserves
6. Looking at reserves levels and policies
7. Querying the level of reserves
8. Follow-up action
9. Governing document prohibits holding of reserves

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

However the funds of a charity and its reserves policy can be viewed objectively and challenged from this objective perspective.

1. How cases may arise

• Monitoring. CDD will refer cases to Charity Support for further action where it appears to them that a charity is holding income funds in reserve without justification or a realistic assessment of its needs. They will take accountancy advice before doing so and the referral will explain why they believe there to be a problem.

• A complaint may be received from a member of the public - either by letter or by telephone - perhaps via our Helpline.

• The subject may arise during a visit to the charity.

• A scrutiny of the accounts for an unrelated reason may reveal a potential problem.

• The charity itself may raise the question - perhaps in connection with a possible change to its objects.

• A Press cutting may indicate a possible problem.

• It may come to light as a side issue in the course of unrelated correspondence or enquiries.

2. General approach

It is important that you approach the question of reserves with an open mind. You should not presume that reserves are a bad thing (or that the lack of reserves is a good thing). The level of reserves should be the result of a well-thought-out and prudent policy developed by the trustees.

Neither can you look at the level of reserves in isolation. Before making any judgement you will need to look objectively at all the circumstances of the particular charity including:

• all of its fund balances; and

• the trustees' explanation of the position.

This will need care and sensitivity.

There is no single yardstick by which you can measure a charity's reserves and conclude that they are or are not appropriate.

3. Charitable companies

Company law does not impose an explicit duty on the directors of a charitable company to apply its corporate property within a reasonable time of receipt - see OG 43 B2. But that does not mean that a company is entitled to retain income indefinitely. Potential beneficiaries are entitled to expect that the charity's property will be applied to further its objects unless there are good operational reasons against this. The case referred to in section 3 of OG 43 P1 concerns a trading company rather than a charitable company but it illustrates a similar principle in that the comparable expectations of the members were recognised. Charitable companies will therefore need to have a reserves policy in relation to their corporate property and we recommend that they disclose that policy in their annual report.

Where a charitable company is a trustee of material charitable funds (normally reported as restricted funds in the company's accounts) the reserves policy in relation to those funds should also be produced.

4. Initial action by Charity Support Division

Unless the referral has come from CDD you should check the CDB screen as above and if appropriate contact the Monitoring PB3 Manager in CDD to find out whether they have any relevant papers or information.

You will also need to look at the charity's governing document to ensure there is no provision which expressly prohibits the holding of reserves or alternatively which expressly allows this for specified periods.

You will then need to look at the charity's accounts and annual report - see section 5 of OG 43 B1 and sections 5 and 6 below.

5. Looking at fund balances not included in our definition of reserves

There are three areas where a charity can normally show with authority that its fund balances are not reserves. These are that it holds endowment funds restricted income funds and has funds represented by functional fixed assets. Although you will not normally need to examine these in detail you need to be aware that they can hide significant reserves for instance if funds have been incorrectly classed as restricted (see section 5.1 below). This can sometimes be difficult to pick up from the accounts alone but may be indicated by something in the trustees' annual report or come to light in discussion with the charity or be the subject of some sort of "whistle blowing".

5.1 Are funds authorised?
5.2 Functional assets
5.3 Expendable endowment
5.4 Restricted funds
5.5 Designated funds

5.1 Are funds authorised

Has the charity createdrestricted income and/or endowment funds inappropriately? These can be difficult to find although correctly produced accounts should detail the objectives of funds.

Gifts and legacies should be treated as income unless there is evidence to the contrary (see OG 43 B4). Normally such fund restrictions are created by the donor but a charity can settle property into restricted income or endowed funds if it has the power to do so.

Sometimes charities incorrectly classify designated funds created by the trustees as restricted income funds.

5.2 Functional assets

Functional assets are not "free reserves"; unrestricted investment assets may be "free reserves" (or they may be part of the charity's designated funds - see section 5.5 below). Are any assets described as functional in fact investment assets - for example a property let at a commercial rate?

5.3 Expendable endowment

The charity may have expendable endowment funds. These funds are outside our definition of "reserves" because there is no obligation to spend them within a reasonable period of receipt. However their existence may have a bearing on the level of reserves which it is appropriate for the charity to hold since the trustees are able to convert expendable endowment into income and spend it.

If there is no authority to add income to the endowment (see section 3 of OG 43 B1) and it is not spent it should form part of the unrestricted reserves of the charity.

5.4 Restricted funds

A charity must use restricted funds for their specified purpose. However there is still a positive duty on the trustees to spend those funds within a reasonable time of receipt otherwise they may be in breach of trust.

Trustees may cite proposed expenditure that could properly be met from restricted funds as part of their justification for holding a particular level of unrestricted income reserves. This will not normally be acceptable.

(Each restricted fund is a separate trust. Any particular restricted fund may therefore include reserves of its own - see section 4 of OG 43 B1.)

5.5 Designated funds

Designated funds are described in the Charities SORP as unrestricted funds designated or allocated for identifiable future expenditure. The intention of the SORP is that the future expenditure is identified and a clear intention but you may find that trustees have designated funds for spurious purposes or not provided clear explanations.

Where designated funds form a large part of the unrestricted funds you should look at them in detail. If the charity's accounts have been properly prepared in accordance with the Charities SORP they should show the value and precise purpose of any designated funds. If they do not and the amount of the funds is material you will need to question the charity.

Purposes for which designated funds are clearly acceptable include:

• provision for a grant which the charity is not legally bound to pay but which it has a clear intention of paying;

• a repairs and renewals fund where there is an asset or group of assets clearly identified and the amount is reasonable in relation to the expected repairs account. (There may for example be a five yearly property inspection to which the fund builds up.) Such a fund may even have been set up on our advice - for example an Emergency or Cyclical Repair Fund for an almshouse charity that is neither required nor authorised by the charity's governing document. (Where trustees are required or authorised by the charity's governing document to set up a fund for a particular purpose it is restricted not designated);

• a fund to save for an event which takes place every so often - for example a conference taking place every ten years;

• money put aside for a building project that is planned to be carried out in the future but for which the resources needed cannot be found all at once;

• a fund to cover the future expenses of current life members. Such a fund balance might even be actuarially assessed;

• a fund to provide for the winding down of a project where there is a strong possibility that this might happen though the exact timing is not known. Such a fund may need to take account particularly of possible redundancy costs.

Items which might need to be challenged include:

• provision for some extremely unlikely event;

• a fund set aside to generate income to cover future expenditure (rather than to spend as income). This is because had the money been intended for this it would have been sought or given as an endowment;

• a sum clearly in excess of the amount required for the intended purpose eg a repair fund which greatly exceeds the rebuilding cost of the building.

It will not always be immediately apparent whether designation is appropriate. You will need to:

• consider the purpose of the designation. Is it within the objects of the charity? Is it plausible? There is no point in a small charity putting aside funds for a grandiose scheme which it has no realistic chance of bringing to fruition. Equally there is little point in a charity designating funds for minor purposes which it could expect to fund from current and future income;

• compare the value of the designated assets with the stated purpose. Does it appear reasonable or are the two clearly at odds;

• look at the normal income and expenditure of the charity - the charity may have designated funds for a routine purpose presently funded from current income? If so why do they consider funding from current income will not be possible in the future?

If a charity has designated funds such that it has a nil (or very low) level of reserves a reserves policy will still be required to explain why the trustees think this level of reserves is appropriate.

6. Looking at reserves levels and policies

6.1 Reserves policies
6.2 Possible reasons for holding reserves
6.3 Working capital
6.4 Indications that reserves may be excessive
6.5 Indications that reserves may be too low

6.1 Reserves policies

Section 3 of OG 43 B2 reproduces our guidance to trustees on the importance of having a reserves policy and how it should be formed. The policy should be explained in the notes to the charity's accounts - paragraph 49 of CC19 sets out what information we consider should be included. This advice is now reflected in the Exposure Draft of the revised SORP published in December 1999.

Does the policy seem to be in line with our guidance and realistic? Does the level of reserves seem reasonable in relation to the stated policy? OGs 43 E1 to E11 contain a sample of extracts from charities' stated reserves policies taken from their accounts. OG 43 D1 provides an introduction to and a list of these.

6.2 Possible reasons for holding reserves

Any item mentioned in section 5.5 above as being a valid reason for a designated fund could also be regarded as valid for an element within a charity's reserves. In addition a charity may need to maintain reserves at a certain level in order to:

• protect against a decline or interruption of future sources of income - discretionary grants for example may cease or be reduced and new sources of revenue have to be found;

• provide for regular fluctuations in income and expenditure - incomings and outgoings are unlikely to coincide exactly. Money may need to be set aside to meet regular quarterly or annual bills. Income may peak at a particular time of the year - perhaps as a result of a regular and successful annual appeal - and need to be set aside to cover leaner months;

• ensure continuity in its provision of a service. The service provided by many charities is an integral and essential part of the lives of beneficiaries. To have to withdraw or cut back with little or no notice could cause very real hardship;

• assimilate a large legacy or donation which cannot be spent all at once - it would be unreasonable to insist that a charity spend immediately a one-off windfall out of all proportion to its regular income. (See also OG 43 B4 which discusses circumstances in which it might be appropriate to treat such a gift as endowment);

• assimilate an abnormally large dividend (one which perhaps just fell short of being capable as treated as a partial return of capital investment - see section 1.3 of OG 43 B2).

Trustees need to decide what level of reserves are reasonable and appropriate for their charity and keep that policy under regular review.

6.3 Working capital

The only item which you might find in reserves which should clearly not be found in a designated fund is a sum to cover working capital. (Working capital is that amount of funds needed by the charity to enable it to pay debts (creditors and loans) as they become due and to finance stocks and debtors.) All of these are identified within the current assets and liabilities on a charity's balance sheet.

The amount of working capital that can be justified will vary from charity to charity. As a very general guide few people would take issue with working capital levels representing three to four months gross expenditure. More than this could probably be justified if say grant income arrived in six-monthly or twelve-monthly amounts. But this is a matter for consideration by the trustees. There is no "norm": many charities have very little working capital and some will rely on loans to provide this. What is important is that the level has been properly considered and is reasonable in relation to the needs and particular circumstances of the charity.

6.4 Indications that reserves may be excessive

The following are indicators that reserves may be excessive. But again these figures are not "norms" - trustees cannot avoid the need to consider and justify their position merely by ensuring their reserves are within these limits:

• reserves in excess of three year's gross expenditure;

• the expected income return* on unrestricted investments is significantly above the charity's current gross annual expenditure - say more than twice as much.

As indicated above this guidance should be treated with extreme caution. These are a guide to what you might expect to see not hard and fast rules. Reserves set at these levels are by no means right for every charity. You will need to consider reserves that are much less than this to ensure they are not excessive. (Conversely reserves that are higher may well be justified and prudent.) You must always take into account the circumstances of the particular charity you are dealing with and the considered views of its trustees and recognise that what is reasonable for one charity can never be assumed to be reasonable for another. There are many factors for trustees to take into account when setting a reserves level - and for you to consider when scrutinising a charity's financial position. For example:

• a well-endowed charity with a steady and reliable income from property or other investments may need minimal reserves;

• a charity with a less reliable source of income - perhaps depending heavily on donations from the public - may need reserves as a hedge against fluctuations in this income;

• the objects of the charity and its activities will also affect its need for reserves. An endowed grant-making charity might easily be able to plan and control its expenditure in line with its income. A charity which responds to emergency situations may need considerable reserves to ensure its ability to respond immediately to costly and unpredictable demands for its services;

• a charity whose expendable endowment has grown significantly above inflation may consider that this growth provides an appropriate underpinning to their activities without the need to establish any material reserves. (Trustees of course have the power to convert expendable endowment into income.)

OGs 43 E1 to E11 provide some examples of particular charities' reserves policies the considerations taken into account by trustees and the different conclusions they have reached on the optimum level of reserves. See for instance the contrast in the need for reserves illustrated by the examples at OGs 43 E5 and 43 E6.

6.5 Indications that reserves may be too low

It is quite difficult to identify charities with reserves that are too low. Many charities have little or no working capital but this may not be a problem. Particular areas where low reserves are not a problem are where:

• an endowed grant making trust spends all its income each year; or

• a self help charity with no staff uses up all its income each year.

Where charities are believed to have low reserves it is important to get a feel for whether this is a regular state of affairs or one that has developed over time. Analysis of several years' accounts is needed in these cases.

Situations where a charity's reserves are too low are likely to include those that have little or no reserves but continuing commitments such as:

• assets to maintain;

• employees;

• continuing programmes.

An aggravating feature is if the charity also has an unreliable income stream. A charity with these sort of commitments needs to have a few months expenditure in hand in order to be able to comfortably carry on business.

The main problem with reserves that are too low is that the charity spends much time and effort dealing with the lack of working capital (chasing grants dealing with irate suppliers etc) rather than getting on with the main purposes of the charity. There is also a danger that the charity will not be able to continue working and in a non-company charity the trustees may face a greater risk of having to make payments from their own resources.

On the whole trustees are well aware when reserves are too low. In this case the reserves policy should indicate this and explain what if anything the trustees are doing about it - it is still appropriate to specify a level of reserves that the trustees believe they should hold. If trustees are not aware there is a problem then we might wish to take action to ask them to consider producing a reserves policy.

There are many charities with low reserves that manage to continue from year to year without remedying the reserves problem. In these circumstances there is no reason for us to contact the charity but simply to continue monitoring.

Where the situation is serious a case officer should consider whether the charity needs advice on managing financial difficulties and our publication CC12 may help.

7. Querying the level of reserves

If the accountant agrees that the position needs to be explored further:

• ask the trustees to explain their reserves policy in detail - if necessary providing them with a copy of CC19. The best way of doing this will depend on the circumstances of the case but may be by letter telephone call or visit.

It may be that rather than an overall reserves policy there is some specific use for the income being retained. To establish this ask whether the trustees do in fact have any clear plans for the funds requesting details of:

• the purposes for which the money will be used;

• how these will further the charity's work;

• the amount of funds needed; and

• when they expect to carry out the activities concerned.

Ask the trustees to let you know if they are experiencing difficulties in applying the income - perhaps because of limitations on the charity's area of benefit or because of a significant decline in the number of beneficiaries. You can point out that this is something that we can rectify by amending the relevant provisions in the charity's governing document.

8. Follow-up action

Depending on their reply you may need to challenge the detail of the policy. Does it:

• accord with the guidance set out in this OG and CC19;

• sit easily with any future plans outlined in the charity's annual report;

• take account of a realistic estimate of future income and expenditure and any restricted or designated funds already set aside

If advice confirms that the charity's reserves appear to be excessive or too low see OG 43 C2.

9. Governing document prohibits holding of reserves

Where the trustees can in fact make a sufficient case for holding reserves but there is a clause in the charity's governing document which does not allow them to do so we will need to consider whether Scheme action (or action under s.74 of the 1993 Act - the small charities provisions) should be taken to rectify the situation. (See section 1.2 of OG 43 B2 which explains the need for an express or implied power to hold reserves.)

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

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annual report
CDB
CDD
designated funds
endowment funds
governing document
reserves
restricted funds
SORP / the Charities SORP
trustees

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