Charities face challenges in reporting surpluses or deficits as these can attract critical but often flawed headlines over whether their assets are being managed in the charity’s best interests.
Funds may be received at the end of a financial year, but cannot be spent in that year, leading to a surplus in one year and a deficit in the next. For example, charities recognise legacy income in accordance with accounting rules, often before the bequest is received by the charity, and this inflates their reserves figure.
In contrast, accounting rules mean that, in certain circumstances, grant-making charities must recognise a multi-year grant in full as expenditure when the award is confirmed, but the cash payments will occur across several years. This creates a mismatch between expenditure and cash outflows in the charity’s books and reduces the charity’s reserves level faster than cash holdings.
In most cases, it is good practice for a charity to have a reasonable amount of funds in reserve to protect it in the event of unfavourable or unexpected circumstances, such as a sudden loss of funding or a humanitarian disaster that requires a quick response.
A charity may also put aside a cash reserve to pay for planned future capital or other expenditure, such as a building or upgrading outdated systems. However, capital expenditure is spread across several years in the charity’s books and, therefore, reduces the reserves gradually. Significant cash holdings or an annual surplus or deficit should not be considered in isolation.
In some cases, it is acceptable for a charity to have no free reserves – for example, a charitable trust with large endowments where investment income generated each year is sufficient to pay for all expenditure in the following year.
Charities should ensure their reserves policy is easy to understand and linked to their strategic plan and risk management strategy. Far too frequently, more focus is placed on budgeted income, future income streams and the surplus or deficit for a single year. Reserves end up being considered only once a year when the reserves policy is reviewed as part of preparing the statutory financial statements. In addition, liquidity and treasury management needs to go hand in hand with the reserves policy.
Once the trustees have determined the appropriate level of reserves for the charity and a reserves policy is established, it must be effectively communicated internally and externally. This will help employees, donors and other stakeholders better understand the charity’s current financial position, financial strategy and future fundraising needs.
Ultimately, it is for the charity to determine its target level of reserves and cash holdings and to justify its decision.
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