What's in reserve?
One of the questions we are frequently asked as auditors by charity management and trustees is “how much should we hold in free reserves?”. There is of course no precise answer to this, and it will depend on the nature of the charity and its activities.
What should be obvious is that a clear and precise reserves policy will enable the reader of the accounts to determine whether the target level has been met, whether there is too much or too little in reserve and what the trustees are doing in order to meet its target one way or another. The policy should be based on the operational and strategic plans for the charity moving forward.
So why are “free reserves” so important? The answer is simply that they matter to everyone who has an interest in the charity:
- It provides trustees with a measure of solvency and whether the charity is likely to be able to achieve its future plans
- It provides funders with information on need, especially around core funding, and whether the charity could be considered a “financial risk”
- It provides regulators with information as to whether charitable funds are being applied for the public benefit or whether funds are being stockpiled.
To start off, it is important to understand what we mean by “free reserves”. Definitions are provided in both CC19; The Charity Commission’s guidance on charity reserves, and in the Statement of Recommended Practice; “Accounting and Reporting by Charities” (the SORP) and as you might expect neither are the same, and the terminology between the two differs. Our view is that “free reserves” are unrestricted funds that are freely available to utilise by the charity, excluding unrestricted funds held as tangible fixed assets or programme related investments and designated funds committed for specific future purposes but not included as liabilities in the accounts.
So having established what free reserves are, how do you go about formulating a policy? The reserves policy is an integral part of a charity’s risk management process. It is designed to build some resilience into the charity’s financial management. In determining a policy key factors usually include:
- Potential for loss of future funding
- Unforeseen emergency costs e.g. major building repairs
- Additional unexpected operational costs e.g. temporary staff cover
- A major planned commitment that cannot be met out of usual day to day income
- Funding a short term deficit or cash flow.
In taking account of these factors, trustees and management should have regard as to how long they can continue should there be a shortfall of income, or if there is extra costs, how long they will have to pay these out. From this information the policy on how much should be in reserve can be constructed. The most common reserve policies refer to this on the basis of a certain number of weeks or months expenditure, however, it could just be a calculated absolute number.
Remember though, this should not be a static figure. It should be reviewed regularly in line with the risk management processes and updated as appropriate.
The real difficulty with any reserves policy is whether the charity generates sufficient unrestricted funds to truly be able to achieve its target. Many charities are funded largely by restricted grants or contracts and the ability to generate any sort of surplus is often severely limited. This should be regarded as a risk in itself and some thought should be given as to how the charity might raise unrestricted funds even if relatively small in the short term.
In conclusion, there is no set answer as to how much free reserves a charity should have, but a charity should establish a policy that is transparent and sets out its approach to reserves including a target figure no matter how aspirational this might be.
If you have any questions about your charities reserves, please do not hesitate to contact Philip Griffiths.