This guidance is written for trustees of all types of charities, whether they are companies, trusts or associations. It explains what is meant by the term reserves, the trustees' responsibility to consider whether their charity needs reserves, and what to bear in mind when developing a policy on reserves. This guidance is relevant to charities of all sizes. In annex 2 it describes some of the additional factors that may be relevant to larger and more complex organisations when setting a reserves policy.
It also looks at how trustees must report their reserves policy in their annual report in a way that meets the requirements of the Statement of Recommended Practice: Accounting and Reporting by charities (the Charities SORP) and legal requirements of the Charities (Accounts and Regulations) 2008 (the Regulations).
Exempt charities are not required by the Charities Act 1993 to prepare an annual report and therefore no specific legal requirement is placed on them to report their reserves policy. However, most exempt charities will prepare an annual report under other requirements. Registered Social Landlords and Higher and Further Education Institutions have their own more specialist SORPs which require the preparation of an annual report. Trustees of exempt charities must therefore consider any specific requirements placed upon them by their own statutory regime and any relevant SORP. We strongly recommend that trustees of exempt charities follow this guidance when setting a reserves policy and report on that policy in their annual report as a matter of good practice.
Similarly, charities which are excepted from registration are not required by charity law to prepare an annual report. Nevertheless, many excepted charities do choose to prepare an annual report. In such cases the annual report should include a statement of their reserves policy in line with the Charity SORP's principles. The Charity Commission can also require excepted charities to file an annual report and in such instances a statement of reserves policy is a legal requirement.
Key points about charity reserves
This section summarises the main points for charity trustees when considering reserves and when setting or reporting on their charity's reserves policy. This guidance is based on the requirements of charity law, the Charities SORP and good practice. In particular:
Charity law requires any income received by a charity to be spent within a reasonable period of receipt. Trustees should be able to justify the holding of income as reserves.
Reserves are that part of a charity's unrestricted income funds that is freely available to spend.
Where the trustees have a reserves policy, this policy must be set out in the trustees' annual report.
If the trustees have not set a reserves policy, this should be stated in the trustees' annual report.
A good reserves policy takes into account the charity's financial circumstances and other relevant factors.
It is good practice to monitor the level of reserves held throughout the year.
It is good practice to keep the reserves policy under review to ensure it meets a charity's changing needs and circumstances.
C. Understanding reserves and the need for a reserves policy
C1. What are reserves?
The short answer
Reserves are that part of a charity's unrestricted funds that is freely available to spend on any of the charity's purposes. This definition excludes restricted income funds and endowment funds, although holding such funds may influence a charity's reserves policy. Reserves will also normally exclude tangible fixed assets held for the charity's use and amounts designated for essential future spending.
In more detail
The Charities SORP defines reserves as that part of a charity's income funds that is freely available to spend. Reserves therefore exclude endowment or restricted income funds which have particular restrictions on how the funds may be used. Trustees need to consider how the funds of the charity are held and how they are being used in order to identify those resources that are freely available to spend.
Unrestricted funds
The starting point for calculating the amount of reserves held will normally be the amount of unrestricted funds held by a charity. However, part of the unrestricted funds of a charity may not always be readily available for spending. Examples of this are:
Tangible fixed assets: the Charities SORP specifically allows funds held as tangible fixed assets for charity use to be excluded from reserves. This recognises that certain assets will be used operationally and their disposal may adversely impact on a charity's ability to deliver its aims.
Programme-related investments: where a charity makes programme- related investments solely to further its charitable purposes, then such investments can be excluded from reserves.
Designated funds: where unrestricted funds are earmarked or designated for essential future spending, for example, to fund a project that could not be met from future income alone they can be excluded from reserves. In such cases the reserves policy should explain the nature and amount of the designation and when the funds set aside are likely to be spent. It is never acceptable to set up designations simply to reduce the stated level of reserves.
Restricted funds
Restricted funds fall outside the definition of reserves, but the nature and amount of such funds may impact on a charity's reserves policy. Where significant amounts are held as restricted funds the nature of the restriction should be considered, as such funds may reduce the need for reserves in particular areas of the charity's work. These factors and their potential impact on the reserves policy are explained in Annex 2 of this guidance.
Reserves held by subsidiaries
A charity may carry out activities through one or more trading subsidiaries and, in such cases, group or consolidated accounts may be required. Group accounts show the activities and resources of the charity and its subsidiaries. Where group accounts are prepared, the annual report will provide a narrative of the group's activities. In particular, the amount of reserves stated must take account of the net assets of subsidiaries.
C2. Why is a reserves policy important?
Short answer
A reserves policy explains to existing and potential funders, donors and other stakeholders why a charity is holding a particular amount of reserves. A good reserves policy gives confidence to stakeholders that the charity's finances are being managed and can also provide an indicator of future funding needs.
The Charities SORP requires a statement of a charity's reserves policy within its annual report. In addition, if a charity operates without a reserves policy, the Regulations require this fact to be stated in the annual report.
In more detail
Deciding the level of reserves that a charity needs to hold is an important part of financial management and forward financial planning. Reserves levels which are higher than necessary may tie up money unnecessarily. Holding excessive reserves can unnecessarily limit the amount spent on charitable activities, reducing the potential benefits a charity can provide. However, if reserves are too low then the charity's solvency and its future activities can be put at risk.
All charities need to develop a policy on reserves which establishes a level of reserves that is right for the charity and clearly explains to its stakeholders why holding these reserves is necessary.
A reserves policy provides essential accountability to funders, donors and other stakeholders. A good reserves policy will explain how reserves are used to manage uncertainty and, if reserves are held to fund future purchases or activities, it will explain how and when the reserves will be spent. A reserves policy provides assurance that the finances of the charity are actively managed and its activities are sustainable. In particular, a reserves policy can help to:
give confidence to funders by demonstrating good stewardship and financial management;
demonstrate the charity's sustainability and capacity to manage unforeseen financial difficulties;
give voluntary funders, such as grant-makers, an understanding of why funding is needed to undertake a particular project or activity;
give assurance to lenders and creditors that the charity can meet its financial commitments; and
manage the risk to a charity's reputation from holding substantial unspent funds at the year-end without explanation.
Developing a reserves policy is also an important part of the internal financial management of a charity. Developing a reserves policy is likely to:
Assist in strategic planning, for example, considering how new projects or activities will be funded.
Inform the budget process, for example, is it a balanced budget or do reserves need to be drawn down or built up?
Inform the budget and risk management process by identifying any uncertainty in future income streams.
We recommend that charities develop their reserves policy in an integrated manner, recognising that strategic and financial planning informs the development of reserves policies and vice versa. For example, the budgets will identify peaks and troughs in cash flow and the reserves policy will need to ensure the troughs in funding can be met from reserves held.
C3. How should a reserves policy be developed?
Short answer
Trustees need to understand the nature of any restrictions on the use of the charity's funds they hold. Budgets and future plans need to be considered, in particular any uncertainty over future income or the risk of unexpected calls on the charity's funds. In looking at future plans, projects or other spending needs might be identified that cannot be met from the income of a single year's budget alone. The identification of these factors might point to a need for reserves.
Having identified why reserves might be needed, trustees then need to think about how much might be required and how much is currently held as reserves. The decision made on these matters and the quantification of the amounts that need to be set aside forms a charity's reserves policy.
In more detail
There is no single method or approach to setting a reserves policy. The approach adopted will vary with the size, the nature and complexity of activities and the nature of funds received and held by a charity. However, for all charities, setting a reserves policy will involve:
Consideration of the nature of the funds received and held by the charity - are the funds unrestricted or restricted income, or expendable or permanent endowment? This understanding allows trustees to identify unrestricted funds which can be spent on any purposes of the charity.
Larger charities are likely to have a formal risk management process. But all charities need to think about uncertainties they may face in the future and the need to hold some reserves to meet an unexpected call on funds or opportunities that may present themselves.
Larger charities are likely to have strategic and operational plans. But all charities need to think about their future budgets and future projects or spending plans that cannot be met from the income of a single year.
By working through these steps the trustees will be well placed to identify why reserves might need to be held and to quantify the amounts of reserves needed to operate effectively.
Once a reserves policy is set, it should not be regarded as a static policy. The circumstances of a charity will change with time and we recommend that the policy should be reviewed at least annually as part of a charity's planning processes. The amount held in reserves should also be monitored during the course of the year as part of a charity's budgetary processes.
Annex 1 of this guidance sets an approach to setting a reserves policy that can be used by smaller charities which do not hold significant amounts of endowed funds, property or operate a defined benefit pension scheme or carry out activities through trading subsidiaries.
Annex 2 of this guidance sets out an integrated approach for larger charities with more complex activities and structures. An integrated approach to setting a reserves policy will see the development of a reserves policy as a product of strategic and operational planning and budgetary processes.
C4. What level or range of reserves is required?
Short answer
There is no single level or even a range of reserves that is right for all charities. Any target set by trustees for the level of reserves to be held should reflect the particular circumstances of the individual charity. To do this, trustees need to know why the charity should hold reserves and, having identified those needs, the trustees should consider how much should be held to meet them.
In more detail
The charity's target level of reserves can be expressed as a target figure or a target range and should be informed by:
its forecasts for levels of income for the current and future years, taking into account the reliability of each source of income and the prospects for developing new income sources;
its forecasts for expenditure for the current and future years on the basis of planned activity;
its analysis of any future needs, opportunities, commitments or risks, where future income alone is unlikely to be able to meet anticipated costs; and
its assessment, on the best evidence reasonably available, of the likelihood of each of those needs that justify having reserves arising and the potential consequences for the charity of not being able to meet them.
Trustees who hold reserves without attempting to relate their need for reserves to factors such as these will have difficulty in satisfactorily explaining why they hold the amount of reserves that they do.
C5. What steps should trustees take to maintain and monitor reserves at the target level?
Short answer
Reserves are held to help the charity operate effectively. Trustees should keep their reserves policy and the level of reserves held under review. Trustees should also monitor the level of reserves held throughout the year. In this way trustees will be aware of the build up of excess reserves or of reserves being unexpectedly or rapidly depleted.
In more detail
Having set the reserves level or range in which it is desirable to operate, it is important to monitor the reserves actually held to establish the reason for any significant difference with the target level set. If reserves during the year are below target or exceed target, the trustees should consider whether this is due to a short-term situation or a longer-term issue. Action may be needed to replenish or spend reserves.
The trustees' monitoring of reserves should not just be a year-end procedure. How the level of reserves changes during the year can be a good indicator of the underlying financial health of the charity and can be an indicator of potential problems. The level of reserves should be monitored throughout the year as part of the normal monitoring and budgetary reporting processes.
In particular, trustees should:
identify when reserves are drawn on so that they understand the reasons and can consider the corrective action, if any, that needs to be taken;
identify when reserve levels rise significantly above target so that they understand the reasons and can consider the corrective action, if any, that needs to be taken;
identify where the reserves level is below target, consider whether this is due to short-term circumstance or longer term reasons which might trigger a broader review of finances and reserves;
regard the ongoing review of the reserves level, target and policy as part of managing the charity;
ensure that the reserves policy continues to be relevant as the charity develops or changes its strategy and activities;
review the statement on reserves in the trustees' annual report where there have been significant changes in the reserves policy or level of reserves held.
Charities with very low or no reserves which face financial difficulty should also read our guidance Managing financial difficulties and insolvency in charities (CC12).
D. Explaining reserves in the annual report
D1. Must we explain our reserves in our annual report?
Short answer
Yes, the Charities SORP requires all charities preparing accruals-based accounts, other than those charities following a more specialist SORP, to set out their reserves policy in their annual report. The Regulations also require a charity that does not have a reserves policy to state this fact in their annual report.
In more detail
The Charities SORP requires trustees to include in their annual report:
a statement of their policy on reserves;
the level of reserves held and an explanation of why they are held;
where material funds have been designated, the amount and the purpose of the designation should be explained;
where designated funds are set aside for future expenditure, the likely timing of that expenditure.
These requirements of the Charities SORP are given legal force by the Regulations which also require a statement in the event of a charity not having a reserves policy.
Our guidance publication Charity Reporting and Accounting - the essentials April 2009 (CC15b) provides a helpful checklist of the content of an annual report.
D2. What happens if our charity has no need of reserves or has excess reserves?
Short answer
It would be unusual for a charity, of any size, to operate without any reserves. However, if trustees conclude that the charity can prudently carry out its planned activities without reserves then this should be explained in their annual report. If a charity has excess reserves then trustees should consider how these funds might be effectively used in the future. If the resources are more than it could reasonably use to fulfil all of its purposes then the trustees should contact us to discuss whether the purposes of the charity should be amended to enable the charity to operate more effectively.
In more detail
Reasons for not having reserves
Whilst it would be unusual for a charity to choose to operate without any reserves, our earlier study, Small charities and reserves (RS5),found that in some cases trustees deliberately chose to hold no reserves. Some trustees budgeted to spend all the income received each year on the charity's activities.
Such a policy can create financial risk from the possibility of unforeseen expenditure, a shortfall in income or an inability to control costs. Trustees choosing to adopt a 'zero level' reserves policy should consider the financial and other risks inherent in such a policy and must explain their policy in the Trustees' Annual Report.
Charities with more resources than they need
A charity with excess reserves should consider whether these funds could be effectively spent on the charity's purposes. If a charity has more resources than it needs to fulfil all of its purposes then the trustees should contact us to discuss whether the purposes of the charity should be amended to enable the charity to operate more effectively.
E. Other questions about reserves
E1. Can a charity invest its reserves?
Short answer
Yes, reserves can be invested. However, by their nature, reserves tend to be resources that may be needed in the short- to medium-term. Trustees therefore should ensure that reserves are invested in a way can be readily realised as cash, when needed.
In more detail
When significant resources are held in reserves from year to year, the trustees should consider whether some or all of the reserves can be invested to obtain a financial return for the charity. In making the investment decision, the trustees should consider when the reserves might be needed (liquidity of the investment) and the acceptable level of investment risk.
The investment policy adopted will need to reflect the trustees’ assessment of the likelihood that some or all of the reserves held may need to be accessed at short notice. Certain investments are more appropriate as long-term holdings and may be unsuitable or too high risk when it is known that a specific amount of cash will be needed in the short-term or at short notice to meet urgent need.
For charities with small sums to invest their investment policy for reserves may be very straightforward, such as holding any surplus funds with a UK bank or building society in an interest bearing account linked to the charity's current account with the provision for same-day money transfer.
Where the amount of reserves held is large and the trustees decide to invest all or part of those reserves in a wider range of investments than simply on deposit, then a more detailed analysis of why the reserves are held and how quickly those reserves may need to be accessed may be required. This should involve a more detailed consideration of the risks for which the reserves may be needed and the time frame in which cash might be required. Investing reserves in assets other than cash also involves a greater degree of investment risk. For example, investing in shares and corporate bonds offers the potential of a higher investment return but also carries a greater risk of loss.
Charities subject to statutory audit are required by the Charities SORP and the Regulations to set out their investment policy, including their investment objectives and the performance of the investments against those objectives in the trustees’ annual report. This requirement also applies to invested reserves.
For further advice on investments refer to our guidance Investment of Charitable Funds: Basic Principles (CC14) - more detailed guidance is also available on our website for those that require it.
E2. What is the legal basis for holding and reporting reserves?
Short answer
Trustees of every charity must ensure that the charity's funds are used appropriately, prudently, lawfully and in accordance with the charity's purposes for the public benefit. The general principle of trust law is that funds received as income should be spent within a reasonable period of receipt. The holding of reserves will be authorised either by using an express or implied power to hold reserves. Trustees are justified in exercising their power to hold income reserves, whether express or implied only if, in their considered view, it is necessary in the charity's best interests.
In more detail
Charity trustees have a general legal duty to spend income within a reasonable time of receipt. Trustees may spend this income to fund charitable activities, in acquiring assets to use in the charity’s work, and in meeting the day to day running costs of the charity. To hold income in reserve rather than spending it, trustees rely on an explicit or implicit power to hold reserves and they must use that power in the charity’s best interests.
The charity's governing document may, in some cases, explicitly give the trustees an express legal power to hold income in reserve instead of spending it promptly. This power is not common but it is still worth checking the governing document in case there is such an express power to hold reserves.
The more common situation is that trustees will have to rely on their implied power to hold reserves. An implied power will not be written into the governing document but is a power implicit in trustees' duties enabling them to take actions which are necessary for the charity to function properly. Trustees are justified in exercising their power to hold income reserves, whether express or implied, only if in their considered view it is necessary to do so in the charity's best interests.
The power to hold reserves needs to be used appropriately by trustees. If the power is used without justification then the holding of income in reserve might amount to a breach of trust. A failure to report on the reserves policy adopted can indicate that trustees have not exercised their legal power correctly. However, good reporting of a charity's reserves policy can help to demonstrate the legal power to hold reserves has been properly used.
E3. Can trustees accumulate income funds?
Short answer
A power to accumulate income by adding income to the capital of an endowment fund should not be confused with holding income as reserves. A small number of charities have a power in their governing document to add income of the charity to capital of an endowment fund. Income cannot be accumulated in this way unless the trustees have an express power that allows them to do so.
In more detail
On occasions, some charities inappropriately add income to the capital of their endowment funds. On other occasions, some charities have, over a number of years, inappropriately invested income to build up a fund which is regarded by the trustees, for all practical terms, as an endowed fund unavailable for spending. These practices are unacceptable unless there is an express power to accumulate.
If trustees want to accumulate income they should check their governing document to see if there is a power of accumulation which allows trustees to convert income into endowment. Converting income into endowment takes the converted resource outside the scope of reserves (since the definition of reserves does not include any endowment funds).
Even if trustees have a power to do so, trustees can only accumulate for a maximum period of 21 years from the first day when the income can be accumulated or, where the governing document so provides, for the period up to the death of the settler (section 14 of the Perpetuities and Accumulations Act 2009 which came into force on 1 April 2010). It is possible for the court or the Commission to authorise accumulation for a period longer than the statutory maximum in appropriate circumstances.
If funds are accumulated without a power to convert them to endowment then they continue to be income funds. Such accumulated unrestricted income funds count as reserves and must be reported as such in the annual report.
In some circumstances there may be doubt as to whether a donation or legacy is a gift of income or endowment funds. If any evidence exists, or can be inferred, from the circumstances of the donation or legacy, that a donor or testator had a specific intention one way or the other, the trustees must treat the gift or legacy accordingly. If there is no evidence to the contrary the donation must be treated as income and used in a way that is consistent with any terms of the gift and the charity's governing document.
E4. What are the tax issues involved in holding reserves?
Short answer
The justifiable retention of reserves should not have any adverse tax implications.
In more detail
Much of the income received by charities is exempt from Income Tax and Corporation Tax provided that the money is used for charitable purposes only. HM Revenue & Customs' normal practice is to allow tax exemption on income which either has been expended for charitable purposes or has been invested for the benefit of the charity.
Tax exemption is not available if either:
the income has been invested in an investment which is not a "qualifying investment" (within the meaning of Schedule 20 of the Income and Corporation Taxes Act 1988). Investments made for the benefit of a charity and not for the avoidance of tax are likely to count as qualifying investments, but trustees in any doubt whether or not an investment is a qualifying investment will need to take advice; or
the income is retained by the charity without being placed on deposit or otherwise invested for an excessive period.
Trustees should refer to the HM Revenue & Customs website for further information on income tax and corporation tax exemptions and reliefs for charities particularly if the charity or its subsidiaries undertake non-charitable trading activities.
E5. Can charities fundraise and apply for grants or contracts if they have reserves?
Short answer
Yes. It is important when fundraising that trustees maintain the confidence of the public in their charity by being open and transparent about their charity's need for funds. If the charity has excess reserves, the trustees should ensure that they do not misrepresent the urgency or need for funds.
When a charity is applying for a grant or is bidding for a contract, it is important that the funder understands the charity's reserves policy and that the policy explains and justifies the reserves held.
In more detail
Every charity is responsible for ensuring that its appeals do not misrepresent the charity's financial position. This is the case whether the appeals are for voluntary public donations, corporate donations, legacies, grants or any other form of income, and whether they are made by advertising, direct mail, in person or by any other method.
If a charity is widely believed to have large reserves, further appeals for funds may provoke resentment against the charity for apparently seeking funds it does not need. In wording its appeals, and in dealing with any reaction to the appeals, trustees should take care not to give anyone the wrong impression about the extent or urgency of their charity's need for funds.
Some charities can have difficulties with the way their reserves are viewed by funders. If the reserves appear too large, there may be an assumption that the charity does not have a need for additional funds. If the reserves appear too low, there could be a refusal to fund on the basis that the charity's finances are unstable and the charity may be at risk of financial difficulty or insolvency.
Trustees should ensure that they can explain their reserves policy to funders by showing that:
the reserves held are based on a policy and a clear understanding of what the money is to be used for;
the charity is operating with sufficient reserves to avoid financial difficulties;
reserves are an essential element of strategic planning; and
the charity is being open to their stakeholders about the level of reserves.
Where trustees are seeking grants or contracts from funders they should ensure that they:
understand the funder's policy towards applicants' reserves;
seek opportunities to explain to the funder their charity's reserves policy and reasons for the level of reserves held; and
present the charity's reserves policy and reserves level in a positive way that is understood.
