Nonprofit Accounting Basics

Confused About Reserves?

Reserves have been a topic long debated amongst management and boards alike. What are reserves? What’s so important about reserves? How much is enough? These are hard questions to answer. We’ll take a look at each of these questions in a series of articles over the next couple of months.

Let’s start by trying to define reserves. While this sounds like an easy thing to do, it can be more complicated than you first realize.

Defining Reserves

Reserves for all nonprofit organizations are a result of accumulated earnings over a period of time. Reserves are excess earnings which are not used for annual operations, but are rather put aside for particular purposes.

How does an organization measure its reserves? The most comprehensive measure – though by no means the simplest to explain – is the organization’s net assets. Net assets are defined easily enough as assets minus liabilities. For the non-accountant, however, this easily defined equation quickly becomes very confusing. Imagine multiple years of operation resulting in both surpluses and deficits. Imagine multiple years of large cash outlays for the purchase of buildings and equipment. Imagine multiple years of borrowing money to make those purchases. (Accountants then depreciate the expense of those purchases over several years, while the debt is repaid over a different number of years.) Imagine collecting funds which have been restricted for specific purposes. Imagine collecting funds which you’re not allowed to use at all.

Most organizations’ board members do not have an accounting background, and therefore could have trouble truly understanding the net assets concept. How many times have you received the question (or wondered yourself), “Why don’t our investments equal our net assets?”

Because of how difficult the concept of net assets can be, organizations sometimes choose to use a combination of non-operating cash and investments (i.e. cash and investments not required for current year operations) as the basis for their reserves. Organizations will often pool these funds together in an investment portfolio and spread them out over a number of investment vehicles.

There are a couple of advantages to using an investment portfolio like this as your designation of reserves. The most obvious advantage is the model of an investment portfolio is easily understood. You don’t have to be a CPA to appreciate excess cash and investments can be used to fund designated needs of the organization. In addition, nearly all of the assets in an organization’s investment portfolio are frequently liquid and available for use as needs arise.

The downside to limiting your designation of reserves to an investment portfolio is that you’re altogether removing liabilities from the analysis. Imagine an organization who borrowed $3,000,000 to help fund its operation. After ten years it has managed to build a non-operating investment portfolio of $5,000,000 but have only repaid $1,000,000 of the debt. Clearly, the remaining $2,000,000 in debt contributes to the true amount of reserves available to the organization. While this may be a simple example, it helps illustrate the point that abbreviating the reserve analysis can inappropriately skew the results.

There are multiple ways to consider reserves and no one approach is necessarily better than the other. Who your audience is and what you are trying to accomplish generally determines the best approach. Whichever model your organization chooses, be sure it is developed by financially acute individuals. And remember – as with everything these days – transparency is king!

Please stay tuned for future articles where we discuss the importance of establishing and maintaining reserves.