OG 43 C1 - Charity income reserves: Scrutinising a charity's reserves policy

In this section...

OPERATIONAL GUIDANCE

CHARITY INCOME RESERVES

RISK FACTORS FOR TRIGGERING REGULATORY INTERVENTION AND SCRUTINISING A CHARITY'S RESERVES POLICY

OG 43 C1 – 15 May 2009

Purpose

Functional responsibility

For action

Charity Services
Compliance

For information

Contents

1. How cases may arise
2. General approach
3. Charitable companies
4. Initial action by Charity Services
5. Looking at fund balances not included in our definition of reserves
6. Initial action, consider the reserves levels and policies
7. Opening the dialogue about the level of reserves
8. Follow-up action
9. Governing document prohibits holding of reserves
Glossary of Terms used in this Guidance

Index to further related information


The Law	Refer to a lawyer	Refer to an accountant

NB. Always check the charity’s case history before querying the level of reserves held by a charity. Even if the reason for the communication or case appears to be unconnected with income reserves, previous correspondence may still have a bearing on any enquiries you make.

Bear in mind that it is not for us to substitute our own judgements for those of reasonable trustees who know the business of their charity, who have taken care to plan properly, and who have justified their plans. It is very important for us to interfere as little as possible with the trustees' discretion to run the charity.

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
	The Assessment Unit will refer cases to Charity Services 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 but Compliance action is not currently justifiable or proportionate. For example a dialogue has not taken place with the trustees (see section 2 below).
	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
	Our regulatory stance is one where we expect charities, via their trustees’ annual report and accounts, to explain to donors and financial supporters their circumstances. A charity should: tell its own story about reserves; explain how its plans for reserves have changed and put their reserves in context; be transparent and provide information which allows stakeholders to form their own views; set their own reserves level for their own unique circumstances and avoid creating any artificial norms or targets that may be inappropriate. With the economic cycle it is likely that reserves may fluctuate from year to year. During an economic downturn, giving may fall and whilst charities take action to ensure their ongoing financial sustainability, their reserves levels may fall. They may also decide to proactively dip into their reserves in order to maintain their activities to assist their beneficiaries during the downturn. Conversely reserves may rise or be rebuilt during favourable economic conditions. Some charities operate in a competitive environment where operational assets are financed by loans and so they may indeed have ‘negative’ reserves. By force of circumstances some charities may have a need for reserves but be unable to build them up and these charities may therefore be at a high risk of disruption or winding up if circumstances become unfavourable. 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 and consider both the regulatory risk factors and mitigating factors when deciding upon on any intervention.
	Our initial approach where a complaint has been received is to refer the complainant to the charity, unless the complainant has already contacted the charity and had a response. Until this has happened it is not proportionate for us to be involved because the trustees have not had the opportunity to explain their position and justify their reserves policy.
	Where the reserves issue has come to light from our own action or where a complainant, having been in communication with the charity, brings the situation to us, we would normally seek to understand the charity’s circumstances and resolve the issue through dialogue rather than the use of our regulatory powers. The case handling is likely to be either by Specialist Casework Division or by Compliance teams outside of an inquiry setting.
	Only after the initial dialogue has taken place, or a fresh dialogue has taken place (if the reserves issue has come up again), and this has shown not to have addressed the matter satisfactorily, would regulatory intervention be a proportionate option (see OG 43 C2).

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 Services
	Unless the referral has come from the Assessment Unit you should check the charity’s case history for any previous cases on reserves or communication on this so that the current matter before you is placed in context of previous dealings with the trustees.
	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 details of any complaint in the context of the charity's accounts and annual report - see section 5 of OG 43 B1 and sections 5 and 6 below. A first step is to consider all the funds available to the charity (see section 5 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 where it holds endowment funds, restricted income funds or 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 ‘whistleblowing’.
	If any of the points set out in sections 5.1 to 5.5 appear to warrant further enquiry, you should seek the advice of a Commission accountant before taking any action.
	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 created restricted 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 reserves; unrestricted investment assets may be reserves (or they may be part of the charity's designated funds - see section 5.5 below). Are any assets described as functional actually 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. Where the restricted funds held back are material, this will not normally be acceptable unless these intentions are reflected in firm plans and explained in the trustees’ annual report.
	(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 reason given but you may find that trustees have designated funds but 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 Repair Fund or Cyclical Maintenance 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 and is of such a size that it cannot be financed from the income in any particular year - 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 provide for the winding down of a project where there is a strong possibility that this might happen though the exact plans have yet to be determined 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.
	Often such consideration will be inconclusive, but where it suggests that the designated assets might be significantly greater than is needed to discharge the purpose or project for which they are designated, or where the purpose itself seems bogus or unrealistic, you should seek advice from a Commission accountant before communicating with the trustees.

6. Initial action, consider the 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

	As a first step consider the following 5 matters when considering the reserves or handling a complaint about a charity’s reserves. Once you have concluded your review take the advice of a Commission accountant before communicating with the charity trustees. The Commission accountant can confirm that your analysis is reasonable and findings justified by the information available to you.

	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 trustees’ annual report – CC19 sets out what information we consider should be included. SORP paragraph 55a sets out the required contents for the annual report.
	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? Does the complaint made about the reserves policy or the level of reserves seem fair?

	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 policy. 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 an abnormally large windfall profit (one which perhaps fell just short of being capable of being treated as a partial return of capital investment).
	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 an overdraft or short term 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.
	Accountants are best placed to give guidance in this area.

	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 years’ expenditure;
	the expected income return on unrestricted investments is significantly above the charity's current gross annual expenditure - say, more than twice as much. (In the event of a ‘total return’ approach to investment being adopted (see section 1.5 of OG 43 B2), the trustees are responsible for identifying how much of the return is spent in the year and how much is retained to meet the needs of future beneficiaries to fulfil the duty of even-handedness. If little seems to be being spent this may indicate that current beneficiaries are being detrimentally treated and that any reserves shown in the accounts and the amount of unapplied total return remaining require our scrutiny.)
	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 this level are not right for every charity; holding reserves considerably less than this level may well be excessive, and reserves of considerably more could also be justified and prudent. You must take into account the circumstances of the particular charity you are dealing with, and the considered views of its trustees. For example:
	a charity with significant endowments and 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 reserves. (Trustees, of course, have the power to convert endowment into income.)

	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. (However, too low, or no, reserves may indicate financial difficulties for the charity.) Particular areas where low reserves are not a problem are where:
	an endowed grant making trust spends all of its income each year; or
	a self help charity with no staff uses up all of 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 hold little or no reserves but have 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 sorts 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, provided the trustees demonstrate through the annual report that they are aware of the charity’s situation, then there is no reason for us to take further action.
	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. Opening the dialogue about the level of reserves
	If, having looked at the charity's accounts, you are unsure of the position, or you have reason to consider that the charity's level of reserves may not be justified, you should check with a Commission accountant.
	Once you have:
	carried out your initial review of the charity’s reserves policy;
	considered the level of current reserves;
	reviewed the factors that may affect the level of reserves;
	considered any information provided in a complaint, and;
	obtained accountancy advice;
	you are in a position to contact the charity trustees.
	In the initial dialogue, either by setting out a summary of your findings or the contents of the complaint, informing the trustees of the issue(s) where an explanation or clarification is needed.
	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, email, telephone call, or exceptionally, by visiting the charity.
	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 assist with by advising on amending the relevant provisions in the charity's governing document. Alternatively, we could advise trustees if they are considering transferring resources to another charity with similar purposes.

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, having considered the trustees' response, you consider the charity’s reserves are excessive or if you are still unsure whether the reserves policy is justified, you should take accountancy and legal advice.
	If this advice confirms that the charity's reserves appear to be excessive or too low, see OG 43 B2.

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 prohibits them from doing so (although this is unlikely to be the case), we will need to consider whether Scheme action (or action under s.74D of the 1993 Act - the statutory power of amendment for unincorporated charities) 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.)

Glossary of Terms used in this Guidance
	annual report
	designated funds
	governing document
	reserves
	restricted funds
	SORP / the Charities SORP
	trustees

Index to further related information