Holding something back in reserve is a bright idea that goes all the way back to the day someone realised it might be wise to stick some meat in the ice at the back of the cave in case no more woolly mammoths passed that way again before spring.

But then, as now, the problem was working out how much to save. Some charities may take the view that because of the nature of their size, aims and operational methods, it would actually be wrong to hold any reserves. Others see the need for a reserves policy as a practical and moral imperative. As Malcolm Watkins, director of finance and operations at the Motor Neurone Disease Association, puts it: “Our trustees and management are very keen not to be holding onto money unnecessarily, but because we believe sustainability is paramount to our beneficiaries we feel this is necessary.”

The SORP requires trustees to provide a statement outlining what reserves are held and for what purpose. In its CC19 document the Charity Commission recommends a policy should outline the reasons why reserves are needed, the level the charity believes is required, the steps it will take to establish and maintain that level, and arrangements for monitoring and reviewing the policy.

Tax law basically requires similar explanations, with the underlying principle being that charities can accumulate income provided it is clear that this is being done to meet future needs rather than to avoid tax. But as Pesh Framjee, head of the unit serving non-profit organisations at Deloitte, has written in a useful white paper Charities and Reserves, what’s most important is that “… management must make a genuine attempt to formulate a reserves policy, rather than just trying to justify the existing level of reserves.”

These are all fairly basic requirements, but charities need to make some complex calculations to meet them properly, starting with a full examination of existing funds and assets, income streams, and expenditures; then assessment of any risks that could affect these figures, and the potential impact of those risks.

It’s also important to understand the true nature of assets. Framjee says many of the charities Deloitte works with find it difficult to identify ‘free’ reserves. Currently, the Charity Commission defines reserves as income that becomes available to the charity and is to be expended at the trustees’ discretion in furtherance of any of the charity’s objectives, not including money already spent, committed or designated for a particular purpose. The remaining amount is said to constitute ‘free’ reserves, excluding permanent endowment, expendable endowment, restricted or designated funds and income funds that could only be realised by disposing of fixed assets held for the use of the charity. The problem for charities is recognising which funds come under those four headings.

In the end it is perhaps the relationship between a fund or asset and the charity’s core purpose that swings the decision one way or the other. The Motor Neurone Disease Association has set the target level for its reserves at the equivalent of five to six months’ general spending to be held in its national office, with total reserves held in its national branch network for one to two months’ spending. At the end of the last financial year the branch target had been met, and reserves equivalent to about four months’ general spending was held at the national office.

Virtually all the charity’s income (the total of which was about £8 million in 2005/2006) comes from donors, so some income streams can be inconsistent, such as that which comes from legacies. MNDA calculates reserves by discounting fixed assets such as computers and buildings, which can’t be used for supporting people with MND. It then takes its total cash reserves, deducts restricted funds, then compares the remaining figure with expected unrestricted expenditure. “That leaves a total of about £4 to £5 million,” says Malcolm Watkins. “If we have that in reserve we believe we should be able to keep up expenditure over any prolonged period of shortfall.”

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Sense, which provides services to people with single or multiple sensory impairments, finds itself in quite different circumstances. It has a much larger income than the MNDA (about £51 million), but much of this is derived from work for local authorities. Its short-term reserve covers the charity for about six and a half weeks, because this is the average length of time it takes for payment from local authorities to arrive. Long-term reserves are targeted to equal 19 weeks’ turnover, or £20 million. At the end of the last financial year the actual figure was £8.4 million.

The policy was severely tested in the 1999/2000 financial year, when Sense was hit by several financial problems: low shop sales figures, low legacy income, high numbers of vacancies in its care homes, and a staffing shortage that led to over-dependency on expensive agency staff. “Fortunately we have got good financial controls, so we could see these trends appearing,” says Derek Pernak, financial director at the charity. “We saw that our main safeguard of six-and-a-half weeks had dropped. We imposed an efficiency savings regime. An approval process was put in place for any expenditure over a certain limit, and we asked staff to forgo a cost of living pay increase, which they were brilliant about doing.”

The experience taught the charity that its six and a half weeks’ worth of reserves could not have kept it functioning, and that it was necessary to formulate a strategy for the absolute worst case scenario. “We realised that we’d have to make sure that if we folded that our service users were transferred to alternative accommodation and our staff were adequately compensated,” says Pernak. “We calculated that we’d need an extra 12-and-a-half weeks to wind down in a responsible and proper fashion.”

The Coram Family, which provides care and support for vulnerable children and young people, has little fundraising capacity, depending instead on income generated by its endowment. Total income last year was £7.2 million, and free reserves stood at the equivalent of six to seven weeks unrestricted spending, with long-term reserves to cover a full 12 months. This is necessary not just because of the nature of the charity’s income, but also the nature of its work, explains Biman Mittra, director of finance and administration.

“Coram focuses on innovative childcare provision with models that are new and untested,” he says. “When you’re at the cutting edge you really need long-term funding, and government and local authority funding tends only to be for two or three years. So it’s important we have our own source.”

As with other charities dependant on an endowment, Coram is very vulnerable to stock market volatility. “When your endowment’s value shrinks significantly it puts at risk a lot of your work,” says Mittra. “So one of the key things that has happened since 2001 is for us to rebuild the capital value of our income. We always have to keep an eye on the relationship between reserves and income. If the value of the endowment has come down you need a strategy to redress that balance. Ours is to rebuild our endowment, which we’ve managed to do quite successfully.”

For other charities, the biggest barrier to hitting a set target for reserves is simply their small size. Gingerbread, which offers help and advice to lone parent families, has an income of about £1.33 million. The charity’s ambition is to hold unrestricted reserves of between £120,000 and £250,000. At the end of the last financial year the actual figure was £31,000.

“Gingerbread has set its reserves at a level of six months’ core expenditure and never been able to achieve this target,” says Bob Cooke, head of finance at Gingerbread. “We are required to put a statement in our annual accounts stating our reserves policy, but users of the accounts can only compare the policy against the actual and wonder about the shortfall.” As he observes wryly, advice in CC19 and the SORP for reserves “can only be aimed at bigger charities than Gingerbread”. Even so, at least the organisation has a policy and is trying to build up its reserves.

Deloitte’s Framjee believes one thing that could make life easier for charities would be a greater degree of understanding from funders. “Many charities funded by restricted funds don’t have the opportunity to build up reserves, because they are required to spend all of their income,” he says. “It’s important that funders recognise that that can be very counter-productive, because when income becomes tight you may have to lay off staff and then re-employ them. If they had a buffer to tide them over that would make the difference.” In the end, an understanding of that simple economic truth, and the will to act upon it, is at the heart of every successful reserves policy, as any prehistoric hunter-gatherer would be happy to confirm.

Further information

You can find Pesh Framjee’s white paper on charities at www.deloitte.com/uk/nonprofit, in the Guidance Notes section. There is also a very useful section on reserves and related topics on the NCVO website in the Ask NCVO section, at
www.ncvo-vol.org.uk/askncvo

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