Reserves: the top five questions asked by NFPs

Reserves: the top five questions asked by NFPs

The recent OCR and interest rate drops (and forecast further drops) have me thinking about reserves for NFPs and charities. 

Over the years I have had several conversations with many different organisations about their reserves. The most common questions I’ve been asked are, how much should we have and what should we do with them? Is it ok to have a deficit and use some of our reserves? Where should we invest our reserves? How should we display them? Should we have a reserves policy?

My answer to all of those questions except the last one is “it depends”.

1 How much should we have and what should we do with our reserves?

The most common answer about the amount of reserves I have come across is six months – and that is as good an answer as any. But six months of what? Does this include operating costs, operating costs plus enough funds to deliver outstanding projects and contracts, or wind down costs?

 I believe the level of reserves and even in what form they are held depends on what they are being held for.

As a minimum you should hold enough cash to allow three months operations if all income suddenly ceases plus an allowance for any possible redundancies, lease pay outs, holiday pay, costs to sell off assets, final accounting and taxation obligations.

It is very rare for all income to cease suddenly. There are often warning signs or patterns of income dropping away.

This level of basic reserve also helps to smooth out temporary cash flow needs in normal operations, but obviously cash reserves dropping below this level is a red flag that needs to be remedied.

If your income streams are very “lumpy” or uncertain, you want to hold more than this level as your basic level of cash reserves.

Extra reserves would depend on what you need them for.

The nature of your organisation and the environment it operates in will drive whether extra reserves over the basic one is required (or at least desired).

Other reasons for reserves could include:

  • database or other IT project replacements
  • moving premises
  • funding for potential legal cases (large ones)
  • future conferences or sporting events
  • large strategic projects
  • restructuring/amalgamations.

 The nature and frequency for the reserve would drive the amount, timing and even how the funds are invested.

 Cash versus equity

One of the more arcane challenges I see is that the organisation will label and separate part of its accumulated funds/equity as its reserves. One of the problems with this approach is that readers of the financial statements (year end or part year) could be forgiven for thinking the $350k in the equity statement marked as basic reserves is available for immediate use.

In fact, equity is simply the balancing item between recorded assets and liabilities (what the organisation owes outside parties). In plain terms this means that the equity could be partially backed by furniture, goodwill, software, computers and other assets that actually have very little ability to be converted to cash.

I monotonously advise anyone that will listen to me that the reserves amounts should be reflected in dedicated cash and near cash. As a minimum the basic reserve should be covered by actual cash. The other reserves should be covered by actual cash, near cash (debtors) and longer term investments.

2 Is it ok to use reserves to fund deficits?

I don’t see why not. If you have reserves that exceed your basic reserve levels and your planned projects or needs – and if the deficit year is planned and is a result of new initiatives or delivery of strategic outcomes – why not?

Even if the deficit level is unplanned, that is what the reserves are for too – to smooth out those unexpected events – but they may need to be replaced.

3 Where should we invest our reserves?

I get asked this a lot, but it’s a tricky one. It’s particularly tricky as I’m precluded from law on giving investment advice (I’m not a registered investment advisor) but I can give general advice on process and concepts.

Usually I tell organisations three main things:

  1. Get professional advice. If you have $1m+ of cash reserve you really need some expert help. Both to discharge your obligations to stakeholders and to understand what the options are out there
  2. Just because you have the same assets / reserves at the end of the year as the start of the year does not necessarily mean you are doing well at investing. You have an obligation to make the most out of all assets and review their effectiveness to the organisation (financial or to help deliver outcomes). This is particularly relevant to property you own
  3. Ask your bank to use sweeps (automatic transfers of balances to interest bearing accounts). The worst investment return is giving free money to your bank

4 How should we display our reserves?

I am a big fan of “jam jar” accounting. This means that if you have different reserves, I suggest displaying them separately on your balance sheet in the equity section and having a detailed note that outlines the reasons and targets for the reserves. This note would mirror your reserves policy.

You may even have dedicated investments on the asset side mirroring the reserves.

The display of your reserves and commentary about intended use is a great tool for AGMs, funders, members and donors to understand why you have that stack of cash on the balance sheet.

In your internal management and Board reporting I find a graph reporting on the reserve levels on a month by month basis is useful for tracking and monitoring (and identifying any shortfalls).

New reporting regime

While the new reporting regime for charities is a great opportunity for the sector to share a common way of presenting their financial statements, there are a few wrinkles in how income is recognised that could have a significant impact on income in advance balances.

Now in some ­­­­situations your organisation might have to recognise the income when received and it will flow straight to your equity.

This may cause confusion for funders and the public so having detailed information on reserves in your financial statements may assist with the perception that your organisation does not need any more money…

5 Should we have a Reserves Policy?

Yes. Whether it is for communication to stakeholders, to comply with reporting requirements or to drive investment decisions, a Reserves Policy is a critical Governance process to assist in the sustainability of your organisation and to achieving its strategy long term.

In fact, a lot of the information above can be codified in a Reserves Policy.

A Reserves Policy should include:

  1. A description of why you have certain reserves and the trigger points for using them
  2. Each reserve should be linked to risk, that is, degree of probability and level of impact – low, medium, high, very high
  3. A description of what level of funds are required in each reserve, how this is calculated and a comparison of current level versus target
  4. Perhaps some guidance for each reserve on the type of investment that can be held to fund them. For example, your base line reserve should be held in a form that is easily turned into cash, a reserve to move buildings in six years’ time could be held in a longer term, less fluid form
  5. Details on the process to review the policy, when it was reviewed last and who can authorise changes
  6. If you have a SIPO (statement of investment policy and objectives), the reserves policy and the SIPO should be aligned

 

John Gill, FCPA

Chair, CPA (Australia) Wellington Branch at CPA Australia

7y

I agree, cash or near cash to cover 3-6 months.

Ally Attwell (QSM)

Self employed I Hanen Certified Trainer (LLLI & SPARK) @ Connect & Inspire

8y

Cool thanks for sharing... I will share this with our board next meeting ;)

Great article Barry, the other thing some NFP's should consider is pulling there resources. Working together and drawing from each others expertise could be a valuable way to say ahead of the curve.

"I monotonously advise anyone that will listen to me" made me laugh. Such is life! Nice article, thanks.

Lisa Gibson

Independent Accounting Professional

8y

Great article thanks Barry - couldn't agree more. Have shared it on my SNZ Finance Network Linked In page.

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