Many charities struggle with the concept of reserves - the accumulation of surplus funds for future use - with false belief that being a not-for-profit means they must not generate a surplus or profit. But, writes BDO’s Leah Russell, good NFP governance relies on effectively managing reserves by assessing risks and articulating a good reserve policy.
Reserves - the accumulation of surplus (funds) available for future use - play an integral role in the financial stability and sustainability of a charity.
Many charities struggle with the concept of reserves. There’s a false belief that being a not-for-profit (NFP) means they must not generate a surplus or profit. This is coupled with the fear that if they do, they may face backlash from donors for appearing to not be doing enough. As a result, they will often run at close to zero or a negative net surplus, putting the charity’s longevity and good work at risk.
Reserves can provide numerous short and long-term benefits. In the short-term, reserves can act as a ‘buffer’ protecting the charity from any unexpected events or sudden costs. In the long-term, they can provide the resources needed for charities to expand their efforts and develop new initiatives to enable them to provide aid to more people.
Our experts are of the opinion that good charity governance relies on effectively managing reserves by assessing risks and articulating a good reserve policy. Communicating the policy to all stakeholders, including the public, is critical. It allows everyone to understand how the profits/surplus will achieve the charity’s purpose.
To assist, we have identified the terms commonly used, in this discussion.
- A Surplus - A ‘surplus’ or ‘profit’, results when the income received exceeds the expenses for accounting purposes. This should be distinguished from net cash inflow or net cash outflows. Several items such as depreciation, asset acquisitions and asset disposals can cause there to be a difference between the result for accounting purposes and the result from a cash flow perspective. Grants to acquire assets or donations received in the form of assets can also result in a surplus but no net increase in cash flow.
- Cash and cash equivalents - This includes cash at the bank and on deposit. This may also include assets easily converted to cash, such as receivables and marketable securities held for sale. Cash may be accumulated to finance an asset acquisition, or it may be held in reserve to finance a particular project.
- Reserves - The term ‘reserve’ is generally used to describe an amount of accumulated surplus that is retained, including those amounts that may be set aside for a particular purpose.
Consequently, the amounts of accounting reserve may or may not be reflected in available cash and cash equivalents. However, the term ‘cash held in reserve’ suggests amounts of cash, deposits and similar are held as available for use by the NFP in the pursuit of its objects.
The critical role of reserves
Some of the common situations facing charities where the development of a reserve can play a critical role in financial stability include:
- Identification of surplus/deficits that relate to the application of AASB 1058, that is where income is recognised when received but the costs have not been incurred to date
- The establishment of a new initiative which struggles to deliver the anticipated outcomes, resulting in the inability to fund future initiatives
- An unexpected reduction in funding, such as the loss of a major donor or grant, as well as any reputational impact as a result of news coverage on the loss
- Unexpected events leading to a sudden increase in demand for services
- Unplanned maintenance, repair and/or replacement costs of vital assets
- Duplication of employee costs if a long-term employee is sick
- Normal month-to-month and/or seasonal fluctuation in donations reduces compared to monthly expenses.
It’s clear that the development of reserves backed by a corresponding bank account is an essential part of good charity governance.
A good practice exercise we recommend for all charities is to plan how they would continue to operate in the circumstance where they were unable to raise funds for one to three months, or needed to spend the equivalent on an unexpected event, such as the recent COVID-19 pandemic, and reduction in volunteers.
This would demonstrate whether the charity had sufficient free cash flow to meet its solvency obligations – the ability to pay its debts as and when they fall due. While there is the possibility of a call for further donations, Australians want to know that the money they give is going to a well-managed organisation who will distribute the funds to those in need.
In the case of the bushfires in Australia, multiple charities came under public scrutiny as to how the substantial increase in donations should have been used. This example highlights that boards and management must consider the implications of relying on special appeals to cover unplanned shortfalls or expenses. Furthermore, when calling for donations for a particular event, they must set expectations by clarifying exactly what donors’ funds will be used for.
What is the appropriate ‘cash in reserve’ for a charity?
This is unique to each charity. The Australian Charities and Not-for-profits Commission does not state what a reserve policy should be as “no single level will be considered appropriate for all charities”. That’s because it depends on the financial circumstances of each charity. However, there are some important factors that charities should consider when deciding on an appropriate reserve. These include:
- What are your sources of income? If the government grants are significant, we suggest considering the impacts of a grant ceasing for any reason and the level of expenditure required to allow the charity to assess the future of that activity.
- Are your long-term grants stable and what steps can the charity take in the case of grant funding ceasing?
- What are the costs of all the charity’s commitments? Such as employee obligations, long-term rental leases and the settlement of any debt if the charity was to close part of its activities.
- Are donors and donations stable each month? Receiving regular direct debits compared to specific appeal-based donations or a few donations from significant donors can all affect the certainty of cash flow.
- If there were no donations for say three months, what is the impact, especially for costs that can’t be deferred?
- What is the likelihood of unexpected natural disasters or events that call upon the services of the charity? For example, many Australian charities plan for an increase in demand for their services during seasonal weather events such as the bushfires in Australia.
- Does the charity have the ability to downsize if faced with changing circumstances or tough economic conditions?
Once the charity has concluded the need for a reserve and the quantum, the next focus should be on determining the funds permitted for generating the reserve, and the events allowed to drawdown on the reserve.
For generating the reserve there are numerous approaches to this, with some charities deciding only to use investment income or a small percentage of each donation.
When it comes to utilising funds, referring back to the reserve policy is essential. The policy should be reviewed and revised each year, to reassess risks and consider past and future needs, as well as where donations will be used.
Finally, the development of a reserve policy will also need to be clearly communicated to donors, explaining the rationale for and importance of the policy – being financially prudent and future-proofing the organisation. Once in place, the reserve should enable the charity to continue to provide its services until the effects of any unexpected events or circumstances are resolved.
At BDO, we have extensive experience in working with boards and management to review policy and procedures considering challenging and complex situations, ensuring that your charity is well placed for unexpected events. Some of the issues that we advise your charity on include, proper governance practices, fiduciary responsibilities of not-for-profit boards, complex compliance issues affecting not-for-profits and compensation and benefits strategies.
For more information contact Leah Russell.
This article, written by BDO’s Leah Russell, Partner, Audit & Assurance was originally published 11 February 2020, and updated 25 July 2022 on the BDO website.