It is crucial for not-for-profit entities to clearly explain the composition and purpose of funds in their annual reports. This helps donors, funders, and stakeholders to better understand the entity’s financial position.
Types of funds
Not-for-profit organisations such as registered charities, charitable companies, trusts, and Charitable Incorporated Organisations (CIOs) can hold a variety of funds as per their governing documents. These funds are divided into three main types:
- Unrestricted funds – The charity may freely spend funds in line with the governing documents and in furtherance of its charitable objectives.
- Restricted funds – The charity must spend the funds in accordance with the funder’s conditions.
- Endowment funds – The charity must invest according to its governing document and/or as per the terms of the endowment to generate future income for the furtherance of the charity’s objectives.
Normally it is relatively straightforward for the reader of the accounts to see how much of an entity’s funds are tied up as restricted and endowment funds. This is because the statutory accounts will usually provide a clear picture of their composition.
However, it is not always clear what purposes the unrestricted funds are being held for at the year-end.
There is no statutory or regulatory requirement to make any accounting disclosures regarding the purpose of the general unrestricted funds held by an entity in the main body of the accounts.
Whilst charities are required to write a trustees’ annual report to accompany the statutory accounts, the Charities Commission does not require charities to explain the purpose of their general unrestricted funds. Therefore, the importance of this is something that is generally overlooked by many not-for-profit entities.
What are the reasons behind holding unrestricted funds
A not-for-profit entity may hold unrestricted funds for various reasons, including:
- General unrestricted funds: To cover the ongoing, regular, and general working capital and expenditure needs of the charity. Quite often, this will be referred to in the charity’s reserves policy, which will stipulate the number of months of forecasted expenditure for which the charity should usually aim to hold reserves.
- Designated funds: For specific reasons or projects, as identified and agreed by trustees, in accordance with the charity’s objectives. This is usually referred to as designated funds, as these funds have been ringfenced from “general” unrestricted funds for a specific use by the trustees.
Why is it important to provide a breakdown of your unrestricted funds in the Trustees’ Report?
In the context of the events and challenges facing the UK Economy, we have recently found that for many not-for-profit entities across the sector, it is becoming difficult to obtain funding.
Funding is often limited and there is considerable competition for the funding that is available.
As a result, funders are scrutinising the data (especially the statutory accounts) in greater detail than they have done before.
Charities must therefore effectively communicate the composition and purpose of unrestricted funds in their annual report to the users of the accounts.
In doing so, this will give more context to potential funders about the charity’s current financial position and its future aims, which can assist them in making a more informed judgement as to whether to provide funding to a charity or not.
How can you explain the unrestricted funds?
The value of unrestricted funds held at any point in time will not necessarily fit neatly with the aimed reserves policy of the entity. For example, the level of reserves could be lower than planned, or a lot higher than desired.
Where the level of unrestricted funds held are lower than planned, it is crucial that the charity uses the trustees’ report to explain this. More clarification will be needed to show how the charity plans to return the level of unrestricted funds to its desired level.
Conversely, where the level of unrestricted funds held is greater than the charity’s stated reserves policy, it is equally important that the charity acknowledges this in the report. Furthermore, the entity could outline the charity’s plans for utilising the excess funds for specific projects or upcoming expenses to further its charitable objectives.
By effectively explaining its funds, the charity is communicating to the reader of the accounts that it is continually monitoring its funds. It also shows:
- It is committed to putting its resources towards the furtherance of its charitable objectives.
- It reflects robust financial planning, which will give potential funders additional comfort and confidence.
We’ve found that in the current economic climate, potential funders are being deterred from funding entities where they see high levels of unrestricted funds. Therefore, it is crucial that you do not miss an opportunity to clearly outline the composition and purpose of the unrestricted funds held by the charity.
If you would like further information or guidance, please get in touch with our in-house expert on charities and the author of this blog, Sumeet.bajaria@myersclark.co.uk.
Have a look at how we work with charities and not-for-profit.