FINANCIAL REPORTING

Reserves – The CFO’s Perspective

“Mommy, where do reserves come from?”

I think that many nonprofit executive directors (ED), boards, and CFOs are looking for the answer to this question. Early on in my nonprofit CFO adventures, from practically the first day on the job, my ED regularly brought up the subject of a “rainy day fund,” but neither of us had any idea how to get one. We eventually figured it out, but it was a long road.

Recently, at an online seminar hosted by the Nonprofit Financial Commons called “Reserves, the Real Deal,” we were asked to type out a word that we associated with reserves. The resulting “word cloud” showed these words among others: savings account, rainy day fund, sustainability, controversial, excess cash, impossible, nest egg, luxury.

One of the presenters at the seminar, Hilda Polanco, has introduced the nonprofit community over the years to the term LUNA:” Liquid Unrestricted Net Assets.1 “Liquid” refers to receivables, cash, cash equivalents, and investments. “Unrestricted” means free of donor restrictions or any encumbrances such as loan covenants. “Net assets” indicates that surpluses gave rise to the cash and are therefore included in the net asset balance on the balance sheet. In her presentation, Ms. Polanco stated clearly that the unrestricted, liquid surplus is the only path to reserves, and recommended that nonprofits build surpluses into their budgets.

For the remainder of this article I will refer to liquid resources as “cash.” So, in essence, the answer to the question “where do reserves come from” is, reserves come from unrestricted cash surpluses.

At first glance, the question and the answer seem simple, but for the CFO, new questions arise. What exactly is a reserve? Is it exactly the same as LUNA? How does a reserve appear on the balance sheet? Is it my net assets? Is it the cash sloshing around in my bank account that I use to manage cash flow? Is it funded depreciation? Is it a board-designated fund? My intention here is to answer these questions from an accounting and reporting standpoint.

UNDESIGNATED CASH RESERVES

Let’s say that the Tiger Lily Garden Association (TLGA), a fictional $2 million nonprofit, unexpectedly receives a bequest of $50,000 in 20×1 which the CFO deposits in the operating bank account. Assuming an otherwise breakeven bottom line at 12/31/x1, TLGA has a surplus of $50,000 on the income statement and an increase in cash and net assets of $50,000 on the balance sheet. If TLGA is struggling to cover payroll every month, it might choose to leave the $50,000 in the operating account to improve its day-to-day cash flow and maybe fend off a few gray hairs for both the ED and the CFO.

Because the $50,000 is an unrestricted cash surplus we could say that it is by definition a reserve. The cash sits in the operating account and the surplus was closed out to net assets on 12/31/x1. Ms. Polanco identified this type as a “cash reserve,” also called a “working capital reserve” or an “internal line of credit.” As long as TLGA does not engage in deficit spending, the reserve will be there forever. But the corollary to “Reserves come from unrestricted, liquid surpluses” is “Deficit spending depletes reserves.” The $50,000 will ebb away if, over time, TLGA spends more cash than it takes in.

Aside from a cash reserve, some common types of reserves are “operating,” “special purpose,” “emergency,” “repair and replacement,” or “opportunity.” These reserves—including an operating reserve—are comprised of excess cash: cash that is not needed for day-to-day operations. Unlike TLGA’s cash reserve, all of these are for potential future needs and might not be used for a long time. If TLGA had not been struggling to pay its bills on time, the $50,000 bequest could have been used to fund one or more excess cash reserves.

DESIGNATED EXCESS CASH RESERVES 2

The lucky organization that experiences surpluses regularly may have reserves in cash and net assets that have never been acknowledged or acted upon. To make the best use of its resources and communicate its plans for use of its excess cash, the organization might consider formalizing its reserves with one or more board-designated funds. By board action, each fund identifies a portion of net assets to designate for an identified purpose, such as those mentioned above.

The first step in establishing a board-designated fund is to identify the cash that is not restricted by donors or encumbered in any other way, and is not needed to fund day-to-day operations. We know that this cash must have come from unrestricted surpluses that were closed out to net assets. So we now have the ability to transform this amount into a board-designated fund. On the cash side, the specified amount can be moved to a separate cash or investment account named for the fund and given its own general ledger account. On the net asset side, the amount of the fund is given its own net asset subaccount and reported separately on the balance sheet.

Establishing a board-designated fund is a project. Management and board will work together to establish a policy that specifies, among other things, criteria for designating and undesignating a fund, criteria for use of the fund, procedures for accessing the fund, and any requirements for replenishing the fund. Effective December of 2017, Accounting Standards Update (ASU) 2016-14 Topic 948 requires disclosure of the existence of the policy (not the policy itself) in the external financial statements. For excellent guidance and a policy template, see “Operating Reserves with Nonprofit Policy Examples” on propelnonprofits.org.

Fixed asset repair and replacement reserves, sometimes called “funded depreciation,” is a common type of board-designated fund. Raising the cash for such a fund is the challenge since depreciation is a noncash expense. Many nonprofit CFOs ignore depreciation until year-end when the auditors insist that it be recorded in accordance with generally accepted accounting principles (GAAP). Organizations tend to assume that grantmakers won’t fund depreciation, but Curtis Klotz has written that including depreciation in a grant application can meet with success. 3 In her presentation, Ms. Polanco advised using the budget process to build reserves. Here, depreciation expense is included in the budget. If a breakeven bottom line with depreciation is achieved, then cash in the amount of the depreciation expense can be added to the board-designated fund account in net assets. I highly recommend segregating the cash in a separate bank or investment account.

Another variety of board-designated fund is a quasi-endowment fund. It is called “quasi” because true endowment funds carry donor restrictions. A quasi-endowment is internally generated with unrestricted cash and exists entirely at the discretion of the board; it can be dissolved by board action at any time. This option is a more formal approach to the board-designated fund and may be used effectively if the organization already has an endowment fund in place; the organization’s endowment policies and procedures can also govern the quasi-endowment fund.

Every nonprofit has its own need for liquid resources for cash management, operations, infrastructure, and special projects. Once the challenge of identifying your reserves is overcome, management and board will be ready to strategize on the amount of net assets to tie up in a board-designated fund and how to invest the identified amount of cash.

Endnotes

  1. Hilda Polanco, The Key to Long-Term Financial Health: Liquid Und Net Assets (LUNA); (New York Nonprofit Press, 5/25/2012) ↑

  2. Placing your reserves in a board-designated fund may affect public perception of your finances. ASU 2016-14 Topic 948 requires that the external financial statements include a “liquidity note” that details the entity’s “financial assets available to meet cash needs for general expenditures within one year.” Assets in a board-designated fund are subtracted to arrive at the final result. Your auditors can help you understand what part this might play in your reserves strategy. ↑

  3. Curtis Klotz, Depreciate Your Way to a Healthier Nonprofit; (Propel Nonprofits Blog April 3, 2014.) ↑