When trustees and the former chief executive of the defunct charity Kids Company were cleared of the disqualification proceedings brought against them by the Official Receiver in February, it reignited debate in the sector about how charities manage their reserves, how and when to spend them, and the challenges in doing so.
One of the main charges made against Kids Company was that it was unable to build up “sufficient reserves”. But this was not for the want of trying, and was something the charity and its trustees had acknowledged over a number of years.
In response to one auditor’s report into its 2012 accounts, the charity said: “One area we have difficulty with [is] the nature of our funding streams: restricted funds do not allow retention to increase reserves, and contractual funding that is less than full cost recovery leaves no surplus to save for the future.
“From a different perspective, Kids Company also promises never to turn away a child in need. This drives growth in charitable spend before growth in charitable income. We acknowledge the risks in this situation, and regularly share these with the government, who are aware of the importance of our work.”
This is the crux of what Debra Allcock Tyler, chief executive of the Directory of Social Change, called one of the “most misunderstood financial terms in the sector”. Under charity law, trustees are supposed to spend money in pursuit of their charitable aims – so hanging on to reserves instead of meeting the needs of beneficiaries is somewhat contentious and difficult to do in practice.
The six-month ‘urban myth’
In her judgment of the Kids Company High Court trial, Justice Falk confirmed that having reserves was not a legal requirement.
“Further, whilst not having reserves might increase the risk of failure, albeit that reserves would not necessarily ensure survival where income fell away, their absence during the charity’s life self-evidently did not make its model ‘unsustainable’,” she concluded.
In response, Allcock Tyler took to Twitter to highlight that many charities will have had to use their reserves to keep going during the pandemic, and questioned whether that should leave them open to similar legal action.
“It is not going to be easy to build [reserves] back up again. Should the trustees close down the charity just in case something goes wrong to protect themselves from prosecution?”
This leaves trustees unable to just sit on their reserves, while funders and donors don’t want their money spent on building them up.
Caron Bradshaw, chief executive of Charity Finance Group, says: “It’s important to understand… some of this toxicity around the reserves debate, and that there is an unwillingness to see back-office as a worthy charitable expenditure in the eyes of many.”
The sector has developed a sort of “urban myth” around the need to keep three to six months of reserves, she says, which often fails to allow for the fact that reserves mean different things for different parts of the sector.
“There’s a logic that on average charities have six months of reserves, so therefore you’re OK for the next six months,” Bradshaw says.
“But there are a whole load of flaws in the argument. First an average is just that, which means charities may have an awful lot less. It also doesn’t take into account the different business models or operating costs.”
For example, if an organisation began the pandemic with six months of reserves, and most of its work comes through government contracts, it is likely to be in a good position.
“But the pandemic has been going for 12 months, so if your fundraising income has stopped overnight, you will have run out of money,” Bradshaw adds.
“A narrative of ‘we have to keep three or six months reserves’ doesn’t reflect the actual risk, and identifying risk relative to a charity’s aims is really what we should be thinking about.”
Struggling to report
In the aftermath of the Kids Company decision the Charity Commission slightly amended its reserves guidance to say that trustees ought to think about retaining money to prevent unplanned closures – something Bradshaw describes as unhelpful.
“What does that mean?” she says. “Do we mean we want charities to never be insolvent? [That] we don’t want them to have an insolvent liquidation? What does that look like?”
Bradshaw says an awful lot of charities live hand-to-mouth, which means there are moments where they are technically insolvent, but know it is more probable than not that supporters and donors will come through.
Research published by the accountancy firm BDO in July last year found that, on average, charities had just two months of operating expenditure in reserves, down from three months in 2017.
The review also found that a number of charities are struggling to accurately report their reserves and some may be failing to comply with regulations. BDO’s examination of trustee reports found almost 30 per cent of the charities it reviewed made no reference to the level of free reserves held, as required by Sorp.
“Improved charity reserves policies and disclosures could help individual charities become more sustainable, and protect the reputation of the sector as a whole,” a BDO spokesperson said in a statement.
“We believe this situation partly reflects a lack of clarity and specific guidance on how to identify and report actual free reserves.”
The Charity Commission says it is continuing to carefully consider the High Court judgment on Kid’s Company, as it considers its own inquiry into the charity.
However, if the regulator is to revise its position on reserves as a result of the most recent Kids Company judgment, Bradshaw says it needs to be done in terms of the actual practicalities the sector has to contend with, and not through a lens of public opinion.