One of the ways in which charity accounts are ‘different,’ is the use of fund accounting.
Fund accounting splits income and expenditure into different pots depending on the purpose of the donation.
There are four types of fund:
1. Unrestricted or general funds – these are funds that a charity has received from a donor and which are not held for any particular charitable purpose. They can be spent as deemed fit by the trustees.
2. Designated funds – these are unrestricted funds that the trustees have set aside for a particular purpose. Such funds can be undesignated or re-designated.
3. Restricted funds – restricted funds have been given to a charity for a particular purpose and can only be spent on that purpose.
4. Endowment funds – these are funds received by a charity that represent capital. Charity law requires trustees either to invest such funds, or to retain and use them for the charity’s purposes.
Knowing the position on each of a charity’s funds at any point in time is an essential part of a charity’s financial management. In particular, there is a need to be able distinguish between unrestricted (including designated) funds and restricted funds. Restricted funds can only be spent in accordance with the requests of the donor; failure to do this may be a breach of trust.
So why else is it important to monitor restricted fund balances?
Planning and budgeting – not identifying restricted funds at time of donation and not allocating expenditure to restricted funds until the year-end can have a distorting impact on your planning and budgeting processes. This may give rise to the expectation that available funds are greater than the true position.
This could result in:
- Encouraging you to plan additional activities thinking the reserves are available to fund them – yet once the fund allocations are done, it may indicate highlight that reserves are lower and so these extra activities may put additional pressures on fundraising or cash flow
- Indications that your reserves policy is not appropriate (see below)
- Indications that your income streams are not sufficiently diverse – for example tracking funds during the year may help to highlight that most of your income is received in the form of restricted grants and therefore there is a need to look at other sources of funding
Reserves policy – every charity needs to develop its own reserves policy that establishes an appropriate level of reserves for the charity to hold. Restricted funds fall outside of the definition of free reserves – but they still impact a charity’s reserves policy.
If the nature of a charity’s activities is such that significant levels of its income and reserves are restricted, then the level of unrestricted reserves the charity should hold may be reduced. However, if restricted fund balances aren’t being monitored, then the reserves policy established may not be appropriate and the charity may be holding too high, or too low, a level of unrestricted reserves.
Keeping track of restricted funds during the year will allow better monitoring of financial performance, unrestricted reserve levels, and the level of unrestricted funds needed – and will help to drive review and setting of the reserves policy.
Donor reporting – it is often the case that that when restricted funds are awarded to a charity, the donor specifies that a report be provided on how these funds have been spent. Such a request may be made for unrestricted funds too. These donor reports will not necessarily coincide with your accounts year-end.
Many charities, both large and small, perform the analysis and allocation of expenditure by fund as part of the annual accounts process. Therefore, you need to make sure that you can easily identify the expenditure connected to each restricted fund at any time during the year. Ensuring that your accounting system allows allocation of income and expenditure to a particular department/project/cost centre should make extracting the information for the donor report more straightforward.
Accounting system and resource –good questions to ask include: does the absence of monitoring funds during the year indicate that your charity has outgrown your accounting system? Is the system still fit for purpose? Does it highlight a training need for your accounts team? Are the trustees receiving the financial information they require?
Overheads – unrestricted funds are often seen as the holy grail of charity financing as they can be spent as the trustees deem appropriate. There can be the belief that “unrestricted funds = overheads”, and that restricted funds cannot be used towards overheads or support costs.
However, this is a slight misconception. Donors are aware that projects and activities don’t just happen – for example, a charity might need premises to carry out its activities so it’s only right that a proportion of premises costs relate to the projects funded by the restricted reserves.
Not tracking restricted funds until the year-end may mean that overheads are not apportioned until the year-end – by this time, the restricted funds may have been spent, resulting in support costs being funded out of unrestricted reserves.
It may also indicate that support costs are not being allocated appropriately – a charity’s activities are likely to change over time (either in terms of what activities are carried out, or the way in which they are carried out). Therefore, previous methods of support cost allocations may not continue to be the most appropriate method.
The above are just a few reasons as to why restricted funds should be monitored on an ongoing basis – but it’s certainly not a definitive list!
Reviewing your charity’s processes around tracking reserves is an important exercise and shouldn’t be dismissed as a year-end accounts process.
Do get in touch if you have any questions on how your charity can best monitor its funds.