Understanding and adhering to the principles of fund accounting is critical for charities and the financial accounts must be clear on the issues relating to funds. The principles of fund accounting are fundamental to trust law and are not merely accounting requirements. Because of the constraints of trust law and the complex area of donor-imposed restrictions, it is vital that proper fund accounting is followed to prevent a breach of trust.
Many charities receive significant amounts of resources where their application is restricted and such restrictions often affect types and levels of services. For this reason, the recommendations are that the resources of a charity should be grouped according to the restrictions on their use as follows:
It is not usually possible to just set up a restricted fund where there was no intention to do so. However, some trustees have specific power to declare specific trusts over unrestricted funds. If such a power is available and is exercised, the assets affected will form a restricted fund, and the trustees’ discretion to apply the fund will be legally restricted.
The key is the donor’s intention when making the gift. The question is: ‘What obligations did the donor actually intend to impose on the recipient of the gift with regard to its use or application?’ If there really is no indication that the donor had any different intention, a gift should be treated as being applicable as income for the general purposes of the charity. If this is not to be the position, the evidence must show that, on the balance of probabilities, the donor intended to apply some different obligation (legal rather than moral) with regard to the application of the gift.
In the landmark equity case of Knight v Knight  3 Beav 148, Lord Langdale MR outlined the three certainties required to create a valid express trust:
It is also not widely known that once a donor has settled property in a trust for a specific purpose they cannot vary that purpose without having reserved the rights to do so. This means that strictly it is not enough to go back to the donor, and it is necessary to go to the Charity Commission to alter the terms of a restricted fund. In practice, grant funders often reserve this right through terms in the grant agreement.
Failed appeals usually happen when insufficient funds are raised for the envisaged purpose and charity trustees believe they have a duty to return funds to individual donors. The Charities (Failed Appeals) Regulations 2008 came into force on 18 March 2008.
The scheme-making powers of the Charity Commission can be used to allow the funds to be applied for other, similar, purposes. However this is often a lengthy process of advertising and offering refunds to traceable donors, and, after the scheme is made, donors have another six months to make a claim. The cy-près doctrine was sometimes seen as being too inflexible and the Act now allows the Commission and the courts to be more flexible and to take into account:
The Commission has explained that this means potential donors can be told at the outset that if the appeal fails then their donation will be used for something similar unless the donor signs a ‘relevant declaration’ saying they would like a refund. The Commission has also clarified that one way to avoid an appeal failing in the first place is for charity to include a more general purpose alongside the specific purpose of the appeal, along the lines of: ‘If we don’t raise enough money to do X then we’ll use it to do Y.’
Since charities have to account separately for all their funds, the assets and liabilities representing the various funds should be clearly analysed. This provides an important indication as to whether or not sufficient resources are held in an appropriate form to enable the funds concerned to be applied in accordance with any restrictions. Therefore, restricted funds for short-term application should be matched with short-term assets and investments. Some charities achieve this by preparing a columnar balance sheet. In practice, knowing exactly what is included in the fund balance can be difficult to achieve and many preparers of charity accounts build the analysis of assets and liabilities table filling in the known amounts and then relying on a balancing figure approach to populate the table.
To maintain the sanctity of funds, all gains and losses on assets held in a particular fund form part of that fund, as does income received or expenditure incurred on account of that fund. Generally, income generated from assets held in a restricted income fund will be restricted income unless the donor has specified otherwise. Conversely, income generated on capital funds such as permanent endowment will be available for general application unless the donor specifies otherwise. Having recognised that income received for a particular purpose must be used only for that purpose, it is necessary to allocate expenditure against special funds. Therefore, expenditure needs to be analysed in a way that enables a proper calculation of what has been expended and what needs to be carried forward as a balance on the restricted funds. This means that the costs of administering and raising funds should normally be charged to that fund. Charities recover the costs of generating restricted income in a number of ways:
Sometimes a charity may incur expenditure before receiving the income restricted for that expenditure. SORP 2005 has adopted a pragmatic compromise and states that where expenditure on a specific purpose has been made in genuine anticipation of receiving restricted income, this expenditure may be charged to the restricted income when it is received.
This treatment is particularly useful for year-end accounting. Where restricted income is anticipated after the year end and money has genuinely been spent on the restricted purpose before the year end, it is acceptable to carry forward a negative fund. This is so long as the temporary borrowing is from a fund which has objects wide enough to cover the expenditure. It is important to note that where the restricted income meets the tests of income recognition, then the income should be recognised as a debtor thus limiting the need for a negative fund.
If the negative restricted income is significant, netting it off with positive restricted funds on the balance sheet may mislead by understating the total of restricted funds. In such cases SORP 2005 requires that positive and negative funds are presented separately on the balance sheet.
In the context of charity law, ‘income’ means all resources which become available to a charity and which the trustees are legally required to apply in furtherance of its charitable purposes within a reasonable period of time. Income funds represent the unexpended amount of such resources. Income funds may be unrestricted or restricted to a particular purpose of the charity.
On the other hand, ‘capital’ means resources which become available to a charity and which the trustees are legally required to invest or retain and use for its purposes. ‘Capital’ may be permanent endowment, where the trustees have no power to convert it into income and apply it as such, or expendable endowment, where they do have this power.
The distinction between income and capital funds is fundamental to charity law and accounting and there can be problems when this distinction is not maintained. I continue to see examples where charities have mixed up the original capital by adding unexpended endowment income to the original endowment capital. The balance on these funds therefore includes:
While it is appropriate for 1 and 2 to be carried forward as capital, 3 and 4 (and 5 if it applies) should not be aggregated with the endowment funds as they are income funds which are available to be expended on the purposes for which they were provided. It is, however, possible to accumulate income as capital where the charity has the power to do so.
The position of endowed funds and charitable companies
Technically, a company cannot hold endowed funds as part of its own corporate property as it is implicit that a company is free to spend any or all of its property.
A charitable company holds its capital and other restricted funds upon trust because the company cannot apply these funds indiscriminately in furtherance of its statutory objects. However, the liability of the members of the company in relation to its acts as trustee is still limited, and the directors of the company are still acting as the company’s agents in relation to the business that the company transacts as trustee. There is no objection, in principle, to the transfer of permanent endowment to a charitable company, but the company will hold the fund as trustees of the trust for investment that affects it. This is so whether the income of the trust is applicable for the objects of the company generally, or only for some particular purpose within those objects.
The Charity Commission has recognised the difficulty faced by some charities with falling income while at the same time the value of their endowment has risen substantially, and some years ago they published a consultation document entitled Endowed Charities – A Fresh Approach to Investment Returns? This considers the issue of allowing endowed charities to follow a total return policy.
In effect, they will invest without regard as to whether the investment return takes the form of a capital gain or income. This is not about giving trustees an unfettered power to spend the endowment or to accumulate income. It is about investing funds solely on the basis of seeking to secure the best total level of economic return compatible with the trustees’ duty to make safe investments, but regardless of the form the return takes.
In England and Wales, the Charity Commission may give the power to adopt a total return approach to investment to charities with permanent endowment. This power may be taken by new charities and will normally be given to existing charities by Order under section 26 of the Charities Act 1993 which specifies required accounting and reporting disclosures. New charities with such a power are expected by the Charity Commission to mirror these disclosures. The key elements of this approach are explained in some detail in SORP 2005, Appendix 3.
If the charity receives a gift of tangible fixed assets or receives income restricted for the purpose of purchasing such assets it would have to consider whether the resource received was a restricted resource.
This raises the question of when a restriction is extinguished. For example, if a charity launches an appeal to build a new hospice, could it sell the hospice one day after it is built and use the funds for other purposes?
In all cases, the intention of the donor would remain paramount. Where it is clear that the donor intended the continuing use of the fixed asset by the charity, the fund would remain a restricted fund with the restrictions being extinguished over the expected useful life of the asset. This could be achieved through the depreciation charge, which would reduce both the net book value of the asset concerned, and the matching restricted fund.
On the other hand, if the charity received a fixed asset as part of an unrestricted legacy, the implication would be that the receipt should be part of unrestricted funds unless the legator specifies that the fixed asset should continue to be used by the charity. For example, a residential care charity which is the residuary beneficiary of a legacy may find that included within the residue is a home. The charity may decide to retain and use the home but this would be unrestricted income. Conversely, if the legator had specified that the home was to be used in a specific way by the charity, then the receipt of the home should be shown as restricted income.
In some cases the donor may donate a fixed asset which may need to be treated as part of permanent endowment. The courts would be very reluctant to allow an immediate disposal of a tangible fixed asset, and the unrestricted use of the proceeds, where it is apparent that the donor had intended that the assets be used in the long term by the charity. In the case where it is clear that a restriction is extinguished on the purchase/completion of the asset the funds should be transferred from restricted to unrestricted.