Charity financial statements are a specialist area and it is easy to make mistakes. In this series we will be briefly highlighting what we believe are the top 10 errors charities can sometimes make when preparing their financial statements. We will look at some of the pitfalls that are common and importantly, how they can be avoided.
Why common errors occur
Charity financial statements are generally more complex than a typical set of company financial statements. This is mainly due to the different types of transactions that can arise (grants in particular can be a tricky area) and the greater prevalence of multiple funds and reserves. So it is not surprising that we often see errors in the draft financial statements of charities.
1. Endowment Funds
Endowment funds are a special type of restricted fund, most commonly seen as ‘permanent endowments’ which take the form of a capital sum that, in itself, cannot be spent but can be used to provide income.
It is a requirement of the Charities SORP that these funds should always be shown as a separate column on the face of the Statement of Financial Activity (SOFA) in addition to any other restricted funds that there may be (subject to the terms of the specific endowment). Failure to separately disclose endowment funds is a common pitfall and one which, ultimately, has the potential to mislead a user of the financial statements.
Income earned on endowed funds is typically unrestricted and will therefore very rarely form part of the endowment itself. The aim of an endowment is usually to provide a future income stream (in the form of investment income such as interest or dividends) to be used for general purposes within the charity, and so the income should reflect that fact. Including this income within the endowment fund is potentially problematic as it may give the impression that this income is ‘locked in’ to the fund and unable to be spent. Sometimes part of the capital element of a permanent endowment can be spent, however, this would normally require prior approval from the Charity Commission.
2. Presentation of the SOFA and supporting notes
One of the key areas within charity financial statements is the overall presentation of the SOFA and supporting notes. Income and Expenditure is often categorised inappropriately, for example voluntary income and activities for generating funds is often included as income from charitable activities and charitable expenditure is not obviously analysed by the charitable activities discussed in the trustees' report. Remember, in the SOFA the charity’s incoming resources and resources expended should be analysed so that the reader can see where its resources came from and what it spent its resources on in the year. Detailed guidance on this area can be found in sections 82-242 of the Charities SORP
3. Fund accounting
Due to the nature of charities and the different types of income that are received, charities could have at least two separate funds shown on the face of the SOFA (most commonly relating to unrestricted and restricted funds). Designated funds often cause confusion as many users mistake them for restricted funds, whereas in actual fact they are unrestricted. The distinction is made because a designated fund is made at the discretion of the trustees (and can subsequently be undesignated), whereas a restricted fund will normally arise due to a restriction imposed by a donor or funder. Problems can arise from the incorrect categorisation of funds which can give users of the financial statements a false impression of the ‘free’ funds that may be available to a charity.
The recognition of grant income can be difficult as there are several factors to consider and it is often an area that is open to interpretation. The three criteria that are required in order to recognise income are: measurability, certainty and entitlement.
- Measurability – this is normally fairly straightforward as there will usually be an agreement which states the amount to be received.
- Certainty – again this is not normally a major issue as the funding is normally received before any thought is given to the recognition.
- Entitlement – this is the area which can cause problems as it depends on whether there are any conditions attached to the grant (for example in relation to performance of specific services or activities). If there are no pre-conditions and, provided the other two criteria are met, then the incoming resources should be recognised when receivable*.
If the grant is conditional then the income should only be recognised to the extent that there is certainty over the conditions being met. For example, a grant may be conditional on a charity obtaining successful planning consent. This is clearly neither certain or wholly within the control of the recipient charity and so in this case the condition of entitlement would not be met and the incoming resource would not be recognised until such time as the conditions were met.
*Additionally it should be noted that the recognition of a grant without pre-conditions should not be deferred, even if the resources are received in advance of the corresponding expenditure.
5. Related parties
There is often confusion over what constitutes a ‘related party’ leading to either insufficient or excessive disclosure. The full definition of a related party can be found in the Glossary of the Charities SORP (GL 50) however there are some key aspects to look out for. The majority of people are familiar with the concept that any charity trustee would be a related party, but this is extended to include any person with the power to appoint or remove a significant proportion of the trustees of a charity.
Additionally charities may be related parties through ‘control’ (where control means that the charity is able to secure that the affairs of a third party institution are conducted in accordance with its wishes). Furthermore any officer, agent or employee of the charity who has authority or responsibility for controlling the major activities or resources of the charity would be considered a related party (as too would any person connected with such an individual). In all instances the related parties should be named and it should also be noted that merely disclosing that transactions are at arms-length doesn’t remove the need to disclose the detail of the transaction.
6. Disclosure of operating lease commitments
This disclosure is required for all non-cancellable operating leases and, whilst not exclusive to charities, is worth noting. The common mistake is to show the total future commitments payable for the remainder of the lease term. However the required disclosure is merely the annual commitment i.e. the amount that will be paid in the coming year.
This should then be split out between leases which expire in:
- less than one year
- within two to five years; and
- in greater than five years.
7. Accounting Policies
These should be concise yet detailed enough to let the user of the financial statements understand how they have been put together. Often accounting policies for certain areas are either too brief or, in some cases, absent. As a rule, any item included in the financial statements (whether debtors, creditors, operating leases, pensions etc.) should have an appropriate accounting policy disclosed in the notes. Without the inclusion of clear accounting policies, users of the financial statements may not be able to understand how certain transactions have been accounted for. This will also hamper comparability with the financial statements of other Charities.
8. Depreciation of fixed assets
For certain fixed assets it is possible to argue that they do not need to be depreciated in the financial statements (ie because the depreciation charge will be immaterial due to the asset having a very long life). However, if this treatment is adopted then the Trustees must conduct an impairment review at each reporting date. This need not be a formal valuation, but there does need to be some form of assessment of the carrying value of the asset and assessment should be disclosed in the financial statements together with an appropriate accounting policy.
9. Trustees’ Report
This is a vital part of any Charity’s financial statements as it is an opportunity to explain the charity’s ‘raison d’être’. Naturally there will be some variation in the length of the report, depending on the underlying complexity of the charity in question, however these variations can sometimes be extreme. Occasionally a Trustees’ Report will be brief but in a number of cases they are overly long and convoluted. It is tempting to include as much detail as possible but 20+ pages of information can be overwhelming for the user.
Often a cleaner, more streamlined approach can have more impact and is certainly easier for the end user to digest. Useful guidance on the necessary elements to include in the Trustees’ Report can be found in Paragraphs 41-59 of the Charities SORP
10. Disclosure of staff numbers
Whilst this is a relatively straightforward disclosure, it is surprising how often it is calculated incorrectly (the most common mistake being that of taking the numbers at a single date such as the year end). The Charities SORP indicates that ‘the average number of staff during the year should be provided’. One of the easiest ways to do this is to use the monthly payroll summaries to count the number of employees in each month and then calculate an average of these figures. If there are a large number of part-time workers (such that this will have a material impact on the calculation) then an estimate of the average number of full time equivalent (FTE) employees for the year may also be included on a voluntary basis (it is not a requirement) in the notes. It is also recommended that the staff numbers are split by category (based on how the charity’s activities are organised).