This is the key finding of our third Charity reserves review. On average, charities were found to hold just two months of operating expenditure in reserves, down from three months in 2017. Our review has also found that improved charity reserves policies and disclosures could help individual charities become more sustainable and protect the reputation of the sector as a whole.
Charity free reserves are a cornerstone of financial management and governance. Free reserves are primarily designed to protect a charity from major risks such as unforeseeable loss of income or reputation and brand damage.
The charity reserves situation has been brought into sharp focus by the impact of COVID-19. The next few months will tell us whether charities free reserves and reserves policies were adequate in order to protect the charities from significant risks and ensure their long-term future.
Free reserves needed to cover both supply and demand
COVID-19 has affected both demand and funding for the charity sector. Most charities are facing increases in demand for their services as more people face financial hardship or need care and support. There is reason to believe that this demand will only increase in the coming months.
The pandemic is, at the same time, decimating charity income; fundraising events have been cancelled or postponed due to social distancing and charity retail was halted for a couple of months and is only now slowly opening. Donation income appears to be holding strong with lower than expected attrition rates.
Charities are approaching the remainder of the year with caution as furloughing ceases and uncertainty over the economy increases. As the UK went into lockdown at the end of March, the income loss was estimated to reach over £4bn in just 3 months. The latest report by Chartered Institute of Fundraising (IoF), NCVO and Charity Finance Group, published in June 2020, found charities are now expecting a 24% reduction, meaning an expected £12.4bn loss of income in the next 12 months.
Following requests from many sector bodies, the Government announced in early April £750m of funding support for frontline charities. However, it is not clear that the support has reached those most in need and there remains a significant gap that charities are struggling to fill. The situation has highlighted the need for robust financial planning and a clearer understanding of the need for reserves and their liquidity.
Inadequate reporting and disclosure?
Our review also found that a number of charities are struggling to accurately report their reserves; some may be failing to comply with regulations. As part of our research we examined the Trustees annual reports. Almost 30% of the charities we reviewed made no reference to the level of free reserves held, as is required by SORP.
We believe this situation partly reflects a lack of clarity and specific guidance on how to identify and report actual free reserves.
Why are charity free reserves important?
Free reserves can be difficult to calculate and challenging to manage, but they are a key financial tool for stakeholders. They are used by charities, stakeholders and funders as a measure of financial health and good governance. Trustees and executives can use free reserves as a measure of solvency of the charity. Funders use free reserves to assess the need for funding requests, while regulators use the measure to ensure a charity is spending funds within a reasonable timeframe.
A charity’s free reserves are cash or liquid funds that can be spent on any of its aims. A charity needs to hold reserves for a number of reasons including:
- Income risk reserve to protect the charity against a fall in income levels
- Cessation reserve to ensure that all liabilities can be discharged in the event of cessation
- Working capital reserve to provide working capital in the event that expenditure is needed ahead of income being received
- Opportunity reserve to provide funding for new initiatives or opportunities
- Adversity reserve to protect the charity against unplanned adverse events such as losing key staff, theft, fire or adverse publicity
Our research on charity reserves
We have carried out research on charity free reserves biannually since 2013. This review looked at the 2018/19 annual accounts of the UK’s 50 largest charities’ by income. We excluded two of the largest grant makers from our analysis because they distorted the figures*.
Defining Charity Free Reserves
The 48 charities we reviewed hold total funds of £19.7bn, of which £6.7bn is unrestricted, including £973m in fixed assets. Their combined unrestricted expenditure is £9.3bn. The charities stated their general free reserves at £3.8bn.
Our review found significant variations in methodologies for calculating reserves. When we recalculated the general reserves to reflect actual, undesignated, liquid assets, the final figure was just £1.5bn. Worryingly, this is £2.2bn less than the charities reported. The single biggest issue is the inclusion of fixed assets, which accounts for £2bn of the discrepancy.
The inclusion of fixed assets in ‘free’ reserves is problematic because the fixed assets are not liquid and so cannot be used as and when they are needed. The value of fixed assets can also be subject to fluctuations and volatility. This means that disposal at short notice, for example to meet a sudden shortfall in income, may have to be done at less than optimal valuations.
However, we are now seeing charities use these assets as security for loans and facilities to manage cash flow in response to the current crisis.
Uncertainty over reserves policies
Charities are required to publish a reserves policy to explain to all stakeholders why they are setting money aside rather than spending it on their principal aims.
A robust reserves policy should set out the following three key elements:
- How much the charity needs to hold in reserve and why
- How and when the charity’s reserves can be spent
- How often the reserves policy will be reviewed
Our review, and our experience working with charities, shows that few charities review and update their reserves policy as part of ongoing financial planning. In almost all cases, the reserves policy is only reviewed at the year end when the statutory accounts are being signed off. Reviewing the reserves a charity holds and why they are held should be part of ongoing financial planning throughout the year – much as reviewing strategy, risk appetite and management information already is.
It is not always clear that charities are designing reserves policies that are fit for purpose. We believe that to be effective and useful, a reserves policy should be risk-focused and assessed against the economic environment. The policy should also take into account the level of working capital required to continue core work. Charities will need an understanding of, and agreement on, what core work the charity wants to protect, how much that costs and how is it funded.
Download an example of a robust reserve policy
Is better guidance on free reserves and reporting needed?
Our research shows there could be more clarity on the levels of free reserves held by charities. The accounts published by charities use very different definitions of ‘free reserves’ and do not provide transparent like-for-like figures. This hampers attempts to establish adequate reserves benchmarks and undermines the resilience of individual charities.
Based on this most recent review and the experience of the BDO Charities team, we are suggesting the following measures to improve the charity free reserves situation. The proposed measures are designed to provide greater transparency and clarity on the whole issue, as well as providing individual charities with clearer guidance.
- The updated SORP should provide an official definition of “free reserves” and make reserves disclosures a mandatory requirement.
- SORP and other guidance should be specific in its disclosure requirements for free reserves and other recommendations, including:
- The free reserve calculation should be set out within the annual report, preferably in table form, so that it clearly reconciles to the accounts.
- The annual report should include a number of years’ free reserves levels and forecasts, preferably with visual representation so that stakeholders can clearly identify trends.
- Fixed asset funds should be identified as a designated fund.
The recommendations above would strengthen the position of charities by helping them to manage adequate free reserves in a robust and transparent manner. They will also provide the charity sector as a whole with robust comparative information on free reserves and reserves policies. In the long run, this will improve the reputation of the charity sector and the sustainability of individual charities.
Rethinking charity reserves
While the current pandemic took many by surprise, and no charity will have expected such huge changes to their cash flow and funding, it does highlight the need for robust reserves to weather the unexpected storms. Those charities with strong liquid reserves have bought themselves more time to respond and react to the implications of the pandemic. It is essential that those reserves used during this period assist charities to come out of this strongly, rebuild, and rethink operating models.
It will be interesting to see the impact COVID-19 has on the way charities view and deal with reserves in the years ahead.
Please get in touch if you would like to discuss our charity reserves review, our recommendations or any aspect of your own charity’s reserves.
*Grantmaking charities Wellcome Trust and the Children’s Investment Fund Foundation UK were excluded from BDO’s research as they were deemed of such size that they distorted the findings.