Understanding restricted funds
Restricted funds can be a challenging area for charity finance teams, but knowing how to recognise them and manage them is essential to avoid being in breach of the law.
Under charity accounting rules set out in the Statement of Recommended Practice (SORP) charities must account for their incoming and outgoing resources as two different types of funds. These are restricted funds and unrestricted funds.
A survey in 2018 highlighted charities valued unrestricted funds twice as much as restricted fundsi. However, restricted funds form an important part of charity funding and its important finance teams understand the difference.
In the commercial sector there are only unrestricted funds which means as that as long as customers receive what they pay for, commercial entities are free to use the income earned in whatever way they please.
But in the charity sector funds may be restricted or unrestricted. This is because, unlike commercial entities who earn income by providing goods or services to customers, charities often receive money from individuals or institutions (donors and funders) who receive no benefits in return.
Special legal powers
The nature of donations gives special legal powers to the donors and funders whereby they can impose restrictions on how their funds are spent by the charities. Failure to apply restricted funding to the purposes for which they are given results in a breach of trust law.
In addition to exposing the charity to the risk of funding being clawed back, the trustees also fail to fulfil their statutory responsibilities by not managing the charity’s finances effectively.
Below I explain how restricted funds are identified and should be managed to better protect the charity from these potential risks.
Definition of restricted funds
The SORP definition of restricted funds is: “funds held on specific trusts under charity law are classed as restricted funds. The specific trusts may be declared by the donor when making the gift or may result from the terms of an appeal for funds. The specific trusts establish the purpose for which a charity can lawfully use the restricted funds. It is possible that a charity may have several individual restricted funds, each for a particular purpose of the charity.”
Restricted funds are either income or endowment (which can be split into permanent and expendable). Restriction is imposed by the donor and may be:
- Used for a specified project.
- For a specific geographical area.
- Funds raised in an appeal such as for the Ukraine appeals must be used for that purpose.
- Investment income (if generated from invested restricted funds).
Funds must be spent for the purpose they were given for. They can also be assets, such as a house given to a charity, but the donor will specify what it can be used for.
Endowment funds are rarer; probably less than 10% of charities will have endowment funds. They are funds whose restrictions relate to the capital element of the assets in question. They are similar to restricted funds in that they are permanent with no ability to spend the capital, and expendable with no requirement to spend capital.
Capital can be invested to generate a return to spend on charitable activities and income generated may be restricted or unrestricted, so its important charities check the terms.
Distinguishing between funds
Restricted funds are generally donations and grants, i.e. funders do not receive anything in return. Commercial transactions are generally unrestricted, e.g. sales of goods and services.
Grants are covered under trust law and contracts by contract law. With grants if the charity fails to use the funds as specified, trustees can be personally liable to return the grants; whereas with contracts they could be sued for damages if they fail to deliver on their agreement, which could mean the damages being higher than the contract value. Also, with grants unused funds can be clawed back, but with contracts surpluses can be kept.
Grants are restricted if the purpose is narrower than the overall objects of the charity, and contracts are usually unrestricted, although under the new SORP there is now the possibility for a contract to be restricted. Accounting treatments will be different depending on whether funds are grants or contracts. There are other indicators too that can help charities tell the difference which include:
- Often the agreement specifies that it is restricted.
- If the charity needs to regularly report on spending to the funders, and if the charity needs prior permission from funders if they spend outside the budget then typically it is restricted.
- If the donor requests an audit/accountant’s certificate at the end then it’s 100% restricted.
- Another tell-tale sign is if VAT applies, the situation is more likely to be a contractual arrangement, and therefore funds are unrestricted.
The key is the terms and conditions, and charities must read the small print. It’s very important that the programme and /or finance team identify when a restricted fund is received to be able to account for it accurately and avoid mistakes being made.
Income recognition
There are three golden rules of restricted grants and donations: entitlement; measurement and probability (i.e. if more likely than not likely to get it then should be recognised as income). A charity can recognise income when all three criteria have been met.
Donations are generally recognised on a receipt basis. No pledges should be accrued, as pledges are not legally binding and so there is no entitlement until received. Whereas grants are recognised on a receivable basis and charities can usually recognise the full amount on the date of the agreement if there are no conditions for grant claims. If there are conditions then they are recognised when the conditions are met.
One example could be: the charity has applied for £12,000 to buy a mini bus, but when does the charity recognise the income? The answer is it’s when the charity receives the letter saying the grant has been awarded. It should not be deferred until the mini bus is purchased, because once the funding is confirmed, the charity has control of when the purchase can be made.
Management of restricted funds
There are four general principles for managing restricted funds. The first is that charities must have systems and controls to ensure the funds are spent on purposes the funds are given for and they can be monitored.
Second, it is recommended charities use separate project codes/cost centres in the accounting system where possible; or keep the records on another database. Third, direct expenditure should be identified such as staff costs and other purchases. Finally, charities should also consider overheads and support costs.
Charities then need to consider what processes are in place to identify restrictions in funding and what the processes of allocation of expenditure are, remembering that elements of restricted expenditure include staff costs, invoices and overheads.
Charities should also be aware that it is possible to transfer funds between restricted and unrestricted. For example, if the costs for the project are greater than the restricted funds then unrestricted funds would be needed to cover the difference. For transfers between restricted funds and from restricted funds to unrestricted funds permission must always be sought from the funder.
Here are some common pitfalls and how to avoid them:
Changes in funding arrangements
Statutory funding from governmental bodies, either central or local, has increasingly been moving from grants to contracts. It is now very common for charities having to submit bids for contracts for services (unrestricted) which they have been providing for years via grant funding (restricted).
It is worth being aware that often the change of the classification of the funding and corresponding expenditure is not picked up by the finance team, especially in the first year following the change of funding framework.
Finance teams are advised to advised to always review the terms of conditions of new funding agreements and not to assume that, just because the services to be delivered and the funding amounts remain the same, the funding arrangements have not been revised.
The change is usually welcome by management, as it allows greater flexibility on how the funding is used and there are fewer financial reporting requirements to consider.
Tax implications
The change of funding arrangements could also lead to VAT implications. Grants are outside the scope of VAT, and input VAT of any corresponding direct expenditure cannot be recovered. However, contracts are generally taxed at 20% unless exempt, which allows charities to improve input VAT recovery. Moreover, if a charity fails to charge VAT on contracts where output VAT is due, it could lead to tax liabilities for the charity. It is therefore worth seeking professional tax advice if receiving funding where the VAT status is ambiguous.
Being over-cautious
Finance teams often allocate only direct expenditure to restricted funds especially when the terms and conditions of the funding are less specific. For example, a charity may receive significant donations for a specific appeal, and the finance team allocates only the direct costs of the appeal to the funds.
Management should consider allocating support costs, too, which is totally acceptable so long as the basis is reasonable and appropriate. This will help avoid unspent funds at the end of the appeal and help with full cost recovery.
Restricted funds can be a complex area, but one that the finance team needs to fully understand.
