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I have heard many explanations from many auditors about reserve funds. It can be a difficult concept for some board members to understand. I've summarized from a presentation Enkel did for Charity Village (below) and I hope it helps your board!
A ‘Reserve Fund’ consists of assets (generally liquid assets) set aside by the organization to provide funding for a planned future need or a cushion for unplanned events or expenditures.
3 Good Reasons to Have Reserve Funds:
To weather the rainy days
- Does your organization have enough resources to continue operating in the event of a pandemic, natural disaster, or economic downturn?
To plan for the long-term
- Are there assets that will need to be replaced? Could there be significant cash outlays required to evolve or maintain operations?
To plan for new programs
- Could there be a significant cash outlay required to start these programs? How do you remain relevant as socioeconomic and demographic factors are changing? Do you need to adapt your programs to a digital format?
2 Misconceptions (+ Truths) About Reserve Funds:
- Having reserves will hurt our fundraising (e.g., Certain grant-makers might not provide funding if the organization has a reserve).
In Reality:
- Reserve funds are an indicator of responsible financial management (Donors and members love that)
- Funders should have more confidence in organization’s ability to carry out mission.
2. An unrestricted reserve is a bad thing.
In Reality:
- Unrestricted reserves allow the organization to react quickly to changing circumstances.
3 Types of Reserve Funds:
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Endowment (Funds invested long term and intended to last a long time, often with donor restrictions attached -- Not discussing here)
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Internally Restricted (Funds with restrictions imposed by the board through a board resolution)
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Externally Restricted (Funds with restrictions imposed by a funder or donor -- Not discussing here either)
3 Types of Internally Restricted Reserve Funds:
Operating Reserves
- To cover the organization’s operating expenditures in the event of unexpected funding shortfalls
Capital Reserves
- To save up for future capital purchases such as new buildings, new equipment or major renovations
Other Reserves
- Depending on the requirements of your organization (NB: Regulated professions need these, especially legal defense, title protection, etc.)
2 Challenges and Their Solutions:
To Build Trust With Board, make sure accurate financial results are presented on a consistent basis.
To Achieve Specified Purpose, the board needs to believe that the specified purpose is achievable and that goals & objectives are clear and aligned. Board should meet regularly to review financials and discuss if the balance in each internally restricted fund is sufficient.
How to Establish a Reserve Fund
● A board resolution that clearly outlines the purpose of the funds (e.g., We are going to put aside X amount of funds to purchase a new building in 10 years).
● A board reserve fund policy that clearly outlines the:
○ Purpose of the funds
○ Definition of the reserve fund, intended use, and calculation of target amounts
○ Assignment of authority for using the reserve fund
○ Responsibilities for reporting reserve fund amounts and use of reserve funds
○ Other specific policies regarding the investment of reserve funds
What is the “Right” Amount to Reserve?
● Is it having sufficient operating cash flow for 1 month, 2 months, 2 years? (NB: I usually see 3-6 months, but I have seen longer)
● Is it enough to wind down the organization? (NB: It takes longer to wind up than you think)
○ Board members are personally responsible for the costs if the organization does not have enough resources to wind down the organization.
Do some scenario planning to forecast your organization’s future needs.
How to “Top up” your Reserves
● Through a board resolution or policy (e.g., We want our operating reserves levels to equal to 3 months of our budgeted operating expenditures). As the organization grows, you’d expect for expenditures to increase and as a result, additional unrestricted amounts will need to be restricted.
Repurposing Internally Restricted Funds
● Requires a board resolution (NB: A note will also appear in your financial statements.
Do We Need a Separate Bank Account for Reserve Funds?
"No, it is almost never required nor advisable for a nonprofit organization to keep restricted funds in one or more separate bank accounts, and this is not an accepted best practice. The reason is that using separate bank accounts for restricted funds makes managing these funds more difficult and does not enhance safeguards or strengthen internal accounting control systems. The opposite often results. Having unnecessary bank accounts can lead to operational inefficiencies and increased chances for errors." (From the Greater Washington Area of CPAs)
Conclusion (Mine)
Your board should definitely have an operating reserve of 3 - 6 months. That is often enough to keep the organization going, or to go sufficiently down the path of winding up. If you are a membership organization, you could also consider a technology reserve fund (have you priced out CRM systems lately?). A capital reserve is a good idea too. Create a board resolution for how much goes in and the date by which it should reach it's determined capacity. When accessing a reserve fund, create a board resolution indicating how much is coming out and (frequently) the date by which that amount will be replaced. Good luck!
/lmwe
Here are the Charity Village/Enkel slides
Video on Reserve Funds (3 Minutes)
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