Article:

Should charities have a reserve?

11 February 2020

Leah Russell , Partner, Audit & Assurance |

Many charities struggle with the concept of reserves. There’s a belief that since they are not-for-profit, they must not generate a profit. And if they do, they fear facing backlash from donors for appearing to not do enough or risk losing their tax-deductible status. As a result, they will often run at close to zero, or have a negative net surplus, putting the charity’s longevity and good work at risk.

However, reserves - which are the accumulation of unrestricted surpluses (funds) available for future use - play an integral role in the financial stability and sustainability of the charity.

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 providing aid to more people.

Therefore, I am 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.

Some of the common situations charities may face where the development of a reserve can play a critical role in financial stability include:

  • The establishment of a new initiative failing, 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, such as the recent bushfires in Australia
  • 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.

In addition, a good practice exercise I 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 bushfires in Australia.

This would demonstrate whether the charity had the sufficient free cash flow to meet its solvency obligations – the ability to pay their debts as and when they fall due. While there is the possibility of a call for further donations, Australians want to know that their donations are going to a well-managed organisation,  who will distribute the funds to those in need. (I’ve discussed some of the key considerations for charities regarding fund distribution in another article here.)

In the case of the recent bushfires in Australia, multiple charities have come under public scrutiny as to how the substantial increase in donations should be used. Therefore, 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 clarify exactly what donors’ funds will be used for.

What is an appropriate reserve for a charity?

This depends on 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 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.
  • 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 cash flow.
  • If there were no donations for 3 months, what costs can’t be deferred?
  • Are your long-term grants stable and what steps can the charity take in the case of grant funding ceasing?
  • 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 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 policy is essential.

With every policy, this should be revised each year, to reassess risks and take into account 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 in light of 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, please see our solutions for not-for-profits or contact Leah Russell.