Reserves—too little, too much

What is right for your association?

By Lyndsey McIntyre CPA, CA

A healthy reserve is an important financial buffer for any association. Not only can it offer savings for a rainy day, provide financial flexibility to fund new activities or fill unexpected funding shortfalls, it also enables you to show your stakeholders that there is a plan or need for an accumulated surplus.

The benefits of a reserve seem obvious—nearly 40 percent of non-profit financial executives identify maintaining cash reserves and financial flexibility as their organization’s primary financial objective, according to a survey by the Center on Philanthropy at Indiana University. However, establishing one is not without its challenges.

Most importantly, you must decide what type of reserve(s) your association needs, define the requirements of the reserve, and determine the appropriate reserve level for your organization. There is no magic number or calculation that all associations can simply apply. Your unique operating environment, financial condition and long-term strategy will all impact your response to these questions.

It’s important to document your thought process when developing a reserve and to clearly demonstrate the purpose for which the funds are being accumulated.  While you want this plan to be robust, it doesn’t have to be overly complicated.  The goal is to ensure that you can clearly support and communicate the need for your reserve. Not only will this prove beneficial from an internal standpoint, it will also allow your organization to show its members and the Canada Revenue Agency (CRA), if necessary, that you are not building up a reserve for the purposes of accumulating profits.

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To help you navigate this complex terrain, below are a few things to consider when developing your organization’s reserves.

First things first

When it comes to developing a reserve, there’s good news and there’s bad news. The good news: there are no specific rules when setting limits or policies around reserves. The bad news: there are no specific rules when setting limits or policies around reserves.

Your policy should be well thought out and provide sufficient documentation to demonstrate that the level of reserve is appropriate. To do this, make sure your association asks (and answers) these three questions:

  • Are your reserves reasonable?
  • Are they appropriate for the nature and size of your organization?
  • Are they justifiable—to your members, other stakeholders and the CRA?

These questions will assist you in drafting a formal reserve policy and plan. The purpose of the plan is to make it easy to justify the reserves to your key stakeholders. No two association’s operations and risk profiles are exactly alike.  This means that each association’s reserve policy should also be unique.  Your reserves should be appropriate to your organization’s specific circumstances.

Reserve types

In determining your needs, you will need to identify what types of reserves your association would benefit from establishing. There are essentially four different types of reserves to consider:

Operating reserves

When an organization has a long-term purpose, best practice says that an operating reserve should be established to cover the normal operating costs of the organization should a funding shortfall arise. Consider this reserve as your “insurance” to ensure the long-term continuity of operations.

Contingency reserves

These reserves are typically established if an association anticipates changes in laws or regulations, a new entrant in the sector, changes resulting from political issues or potential catastrophic events. A reserve for potential payouts relating to HR-related issues may also be appropriate. This reserve plans for the potential impact of an anticipated risk.

Special program reserves

Establishing funds for unique events, new programs, and specifically-restricted grants or gifts are all examples of situations where an association may find it helpful to establish special reserves. The amount of the reserve will typically be linked to the budget approved or the funding provided for the initiative.

Capital reserves

These reserves would be established for a future building, an expansion or other major additions to property and equipment. The amount of the reserve should be tied to the capital needs of the association.

How much?

The type of reserve, or reserves, you require will drive the level of funding needed. While there are various methods you can use, the goal is to show that you followed a process—and the reserve levels you’ve targeted are anything but arbitrary. Let’s go through the steps you should follow:

  1. Build a baseline long-term financial forecast. If reserves are being set up in order to mitigate adverse financial consequences, it is important to create a reasonable picture of what you are protecting against. The analysis needs to be sufficiently robust and detailed in order to provide a reasonable portrayal of where the association is headed or wants to be. This means it would have to include a significant time period—say, five years— to enable management to see trends that may not be evident in the annual budget. You’ll also want to consider all aspects of the organization—from programming to advocacy—and build in growth plans or changes in strategic direction that may occur in the proposed timespan.
  1. Conduct a detailed analysis of potential risks. This means identifying, quantifying and assessing the probability of potential positive and negative swings in the revenues or expenditures outlined in your 5 year forecast. This should be an all-encompassing process, involving each department of your association. This will help establish what level of reserve you require. Potential risks you should consider include: projected investment returns, capital needs, confidence in operational results (revenue and/or expenditures), and the impact of strategic initiatives.
  1. Quantify those risks. When you look at each individual risk on its own, it may not seem like a significant threat to your organization. You must take into account the probabilities of different risks in totality, to establish an accurate overall reserve level rather than looking at each risk in isolation.  This helps us recognize that no forecast is perfect.
  1. Set your target reserve level and funding approach. Start with the targets you’ve built up.  You will need to take into account the economy, the maturity of the association, the risk appetite of the organization, and adjust your target reserve level accordingly. Next, you’ll have to identify whether you have assets available from which to establish reserves.  While some may have adequate excess funds to fully fund a reserve at the outset, many will have to develop a funding plan to accumulate the necessary funds. This is not necessarily easy to do, and will often require making difficult revenue and expenditure decisions.

Let’s put this approach in to practice.  Imagine your organization wants to develop an operating reserve and you’ve determined that your reserve should be sufficient to cover fixed operating expenses.  You will need to define your fixed operating expenses, and period you want covered. 3 months? 6 months?  Answers to these questions will be unique to each association.

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You’ve established a policy and determined the right level.  Now what?  You need to communicate with your Board to not only obtain their approval but to gain their support. Once this has been done, management will need to incorporate the reserve plan in to your annual budgeting process and to start to set aside funds. It will also be key to track and monitor your actual reserves against policy.

Getting to the magic number You now have a supportable estimate of annual fixed operating expenses as a basis for determining reserve levels. This process can be followed regardless of the type of reserve your association is looking to formalize.

A formal plan can make the justification of reserves easier during times when funds may be tight. A plan that takes projected risks into consideration will also help defend reserve levels.  It will also help you determine how those reserves should be invested.  Will you need to draw on your reserves in the short term or the long term?   Your investment policy should be tied to your reserve policy.

Finally, your association is continually evolving.  For this reason, an evaluation of reserve policies should be conducted on a regular basis.

Whatever way you choose to approach it, know that any challenges you encounter on the road to building a sound reserve are well worth the peace of mind that comes with having one.  Remember there will come a time when you will need to draw on those reserves.

Author Bio
Lyndsey McIntyre is a senior manager with Grant Thornton LLP.  Lyndsey is actively involved with Grant Thornton’s not-for-profit leadership group.  The firm works with associations and other not-for-profit organizations providing audit, tax and advisory services. Reach her at [email protected]