Charity SORP

Charity SORP: The accounting terms below are all defined in the context of the Charity SORP. A SORP is a Statement of Recommended Practice. As the name suggests, the Charity SORP provides recommendations for accounting and reporting, in particular, how accounting standards should be applied in the context of the charity sector, and how to account for sector specific transactions. The SORP provides a comprehensive framework of recommended practice for charity accounting and reporting. It provides a mechanism enabling charities to meet the legal requirement for their accounts to give a true and fair view and provides consistency in the sector’s interpretation of accounting standards. The SORP also provides recommendations for annual reporting that are relevant to sector and stakeholders needs and are in line with wider developments in reporting.

Statutory audit versus independent examination

A statutory audit is a rigorous review of an organisation’s financial statements under the Charities Act 2011 and Companies Act 2006. The auditor will form a ‘positive’ opinion on whether or not the financial statements show a true and fair view of the organisation’s finances. Charities require an audit if their gross income is above £500,000 or if their gross assets are above £3.26m and their gross income is above £250,000.

An independent examination on the other hand provides “negative” assurance that “no evidence was found of a lack of accounting records; nor of the accounts failing to comply with the records; nor of accounts failing to comply with the Charities Act; nor are there other matters that need to be disclosed”. An independent examination therefore usually requires less rigorous testing than an audit (and can be significantly cheaper for charities). All charities whose gross income is above £25,000 a year require an independent examination of their accounts. If the charity’s income is above £250,000 (but below the audit threshold), the independent examination must be completed by a qualified accountant.

Balance sheet

A snapshot of an organisation’s finances on a given date. For charities, this includes the value of its “assets”, “liabilities”, and “reserves” as at that date (see below for more on these terms).

Statement of Financial Activities

This is a summary of a charity’s financial performance over a given period. This includes its income and expenditure for that period, as well as a summary of movement in reserves. For certain organisations, it is also called an Income & Expenditure Account (or Profit and Loss Account for profit-making organisations).

Assets

An asset is something of value that an organisation owns. Some assets can be owned over the long term (usually more than 1 year), and these are called fixed assets. E.g. property, equipment, vehicles, etc. Other assets can only be owned for a short term (usually less than 1 year), and these are called current assets. In accounting for charities, current assets will normally refer to either cash or something that can be converted into cash within short time e.g. amounts owed to the charity.

Cash accounting

Cash accounting is where transactions are ‘recognised’ only when cash changes hands. This is also called a “receipts and payments” form of accounting. Non-company charities with gross income of less than £250,000 are entitled to prepare their accounts on this basis.

Accruals accounting

This is a form of accounting where transactions are ‘recognised’ when they occur notwithstanding when the related cash exchanges hands.

Liabilities

A liability is something of value that an organisation owes. There can be long term liabilities i.e. repayable in more than 1 year e.g. loans and mortgages or short term i.e. repayable in less than 1 year e.g. amounts owed to suppliers.

Accruals accounting: Income

In accruals accounting therefore, income refers to any amounts that the charity has become entitled to, whether actually received or not. For example, a small charity with a 31 December year-end receives confirmation of a grant funding to cover costs for quarter 4 to December, but money doesn’t actually get transferred until early January. This amount would be included in income for the year under accruals accounting (but not under cash accounting – see below).

Accruals accounting: Expenditure

In accruals accounting, expenditure is reported when there is a commitment by the organisation to incur the cost. For example, if a charity with a year end of 31 December has a staff Christmas dinner at a rented space, but the invoice is only received in January and the payment is made soon after. The cost of renting the space is included in the year of the Christmas dinner, even if the payment is made the following year.

Accruals accounting: Surplus versus deficit

The difference between income and expenditure in any given financial period is a surplus if income is higher than expenditure, and a deficit if income is lower than expenditure. A charity’s total reserves will increase or reduce over time by the amount of surplus or deficit in each financial period.

Accrued income

Amounts which an organisation becomes entitled to in one period, but payment had not been received at the end of that financial period, and no invoiced had been issued.

Prepayments

Payments made in one accounting period but the goods or services will only be received in future periods. E.g. An organisation whose year end is 31 Dec pays for hall hire in Dec, to use the hall in May the following year. Prepayments are current assets.

Debtors

Amounts owed to the organisation. This is a general term that can also include prepayments and accrued income. A more specific term is trade debtors which refers to amounts owed to the organisation and for which an invoice has been issued.

Deferred income

This is income that has been received (or has been invoiced) in one financial period, but relates to future financial periods. For example, an organisation with a financial year end of 31 December may receive a grant in November, to support activities that will be carried out from January to December the following year. This amount is ‘deferred’ to the following period, as that is when the organisation would “earn” it.

Accruals

The value of expenses that have been incurred e.g. through a commitment but for which no invoice has been received and no payment has been made. E.g. a charity is normally invoiced in arrears for a consultant’s fees. The consultant has done some work in a given accounting period, but at the end of that period, no invoice had been received. The estimated cost that relates to those services is an accrual.

Creditors

Amounts owed by the organisation. This is a more general term which sometimes also includes accruals. A more specific term trade creditors is used to refer to amounts owed to suppliers for which invoices have been received by the organisation.

Liquidity

This is a term used to refer to the measure of an organisation’s accessibility to cash and whether this is sufficient to cover its short term obligations. It’s about how quickly the organisation can increase its cash in order to meet its immediate obligations. We would say that an organisation has liquidity problems if it’s unable to meet its immediate obligations (which is possible even if the charity may not be running a deficit on its Income Statement).

Restricted income

A charity’s income is said to be restricted if: either the donor has stated that the income should be used for a specific purpose or in a certain way; or the charity has created an expectation that the money will be used for a specific purpose or in a certain way during the application or appeal process. Any unused restricted income after all related costs have been charged is carried forward in a restricted reserve.

Unrestricted income

This is income that has no external conditions or expectations on the charity in its use. The charity has discretion as to how the funds will be applied to achieve its objectives.

Direct costs

These are costs that can be directly attributable to a given activity, so they increase or reduce in line with increase or reduction in activity levels. Examples include: printing training materials for a training project; the salary of those employees who are specifically hired for and whose time is dedicated to the specific project; the purchase cost of items for distribution to beneficiaries; etc.

Indirect costs

These are costs that cannot be directly attributable to a specific project. They are sometimes also called support costs, shared costs, or overheads. Examples include office rent, Administration staff salaries, office supplies, etc.

Allocation versus apportionment of support costs

Support costs are normally allocated or apportioned to projects following an agreed cost allocation principles.

Support costs are allocated to a project if the project caused the overhead cost to be incurred – e.g. if the charity has to expand its premises in order to accommodate a new project. Allocable support costs are akin to direct costs. However we can only allocate support costs in this way if the amount can be reasonably known.

Support costs are apportioned if they cannot be specifically identifiable to a specific project. These are therefore apportioned on a reasonable basis to the organisation’s projects or “cost centres”. Reasonable bases of apportionment include: staff time, floor space, and proportion of geographical coverage.

Natural classification versus functional analysis

Charities which are subject to audit by law are required to follow the functional analysis of expenditure. Smaller charities which are below the threshold can follow a natural classification.

Natural classification: This is where income and expenditure are described according to their natural name without categorisations. For example, costs such as rent, travel and subsistence, salaries and wages, telephone, etc. would be shown on the face of the Statement of Financial Activities (or in a Note to the Accounts) with these natural names.

Functional analysis: This where income and expenditure are analysed according to their functional headings. These are:

Incoming resources

Incoming resources from generated funds (including voluntary income, income from activities for generating funds, and investment income)

Incoming resources from charitable activities

Other incoming resources

Resources expended

Costs of generating funds (including costs of generating voluntary income, fundraising trading: costs of goods sold and other costs, and investment management costs)

Charitable activities costs

Governance costs

Other resources expended

As can be seen from the categories above, all natural expenditure lines need to be allocated or apportioned to one or the other category under the functional analysis. Costs are also required to be analysed between activities and between staff, direct, grant-making, and support costs. Support costs may also be analysed between different kinds of support costs e.g. finance, legal, and administration.

Fixed costs

These are costs which remain the same notwithstanding the level of the Charity’s activities. For example, a homelessness charity that provides a sleepover service in the winter days may pay the same amount for rent on each night notwithstanding the number of service users that actually stay. Rent is a fixed cost in this case.

Variable costs

These are costs which will reduce or increase depending on the level of activity. e.g. the costs of buying volunteers’ lunch for a series of campaign activities will depend on the number of events held and number of volunteers for each event. In this case, these are variable costs.

Reserves

A charity’s reserves is the accumulation of its surpluses and deficits over its life. There are two broad categories of charity reserves: restricted and unrestricted reserves.

Reserves versus cash balances

A charity’s reserves do not normally equal its “cash reserves” i.e. the total amount held in cash and bank accounts. This is because there are non-cash items that are included in reserves but not in cash reserves.

In general, a small charity’s reserves comprise:

Bank and cash balances                                                x

Add net book value of fixed assets (see above)        x

Add other amounts receivable (see above)               x

Less amounts payable (see above)                            (x)

Restricted reserves

This is the excess of accumulated restricted income over restricted expenditure. These are sometimes also called restricted funds.

Restricted funds versus deferred income

Deferred income is about income that the charity has received or invoiced but has not yet “earned” i.e. the timing of the related activities is in future periods. Restricted reserves on the other hand represent the excess of income over expenditure on restricted reserves i.e. it’s about the purpose of the income or the manner in which it should be spent, rather than the timing of use.

Endowment funds

These are a special type of restricted funds, often in the form of “permanent endowment funds”, which comprise of a restricted capital fund usually for generating future income for the charity e.g. through interest, rental income, or dividends. Usually, the endowment fund itself cannot be spent, except with approval from the Charity Commission. The income generated is itself unrestricted usually, and mixing it together with the endowment fund can be misleading as this would give the impression that it’s also “locked in”.

Unrestricted reserves (also called unrestricted funds)

These are reserves that a charity accumulates from surpluses on unrestricted income over unrestricted expenditure. It is not uncommon for these reserves to be referred to as “General funds”.

Designated reserves

Designated reserves are a portion of unrestricted reserves that the charity has earmarked for specific purposes. The difference between designated reserves and restricted reserves is that for designated reserves, the purpose requirement is internally imposed, while for restricted reserves it’s externally imposed either explicitly or as an expectation on the charity by external stakeholders.

A charity can have many different types of designated reserves:

Fixed asset fund: This represents the proportion of a charity’s reserves that is tied up in fixed assets – it means that it would be difficult to turn those reserves into cash.

Development fund: Trustees may choose to set aside some funds for expected future costs of exploring new projects or services.

Free reserves

This is the balance of unrestricted funds, after designated reserves have been deducted.