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The voice of Scotland’s vibrant voluntary sector

Published by Scottish Council for Voluntary Organisations

TFN is published by the Scottish Council for Voluntary Organisations, Mansfield Traquair Centre, 15 Mansfield Place, Edinburgh, EH3 6BB. The Scottish Council for Voluntary Organisations (SCVO) is a Scottish Charitable Incorporated Organisation. Registration number SC003558.

Getting to grips with restricted funds

This opinion piece is over 1 year old

Charities have to account for their incoming and outgoing resources as two different types of funds

We recently ran a webinar on restricted funds and how they apply to the charity sector and how to recognise them and manage them.

Under charity accounting rules set out in the Statement of Recommended Practice (SORP) charities have to 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 funds.  However, restricted funds form an important part of charity funding and it’s essential for finance teams to understand the difference.

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.”

In the commercial sector there are only unrestricted funds, but in the charity sector they may be both unrestricted and restricted.  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
  • and investment income (if generated from invested restricted funds).

Funds must be spent for the purpose they were given for. They can be assets, such as a house given to a charity, but the donor will specify what it can be used for.

Endowments 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 – no ability to spend capital
  • and expendable – 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.

How to distinguish between restricted and unrestricted funds

Restricted funds are generally donations and grants ie funders do not receive anything in return. Commercial transactions are generally unrestricted eg sales of goods and services. If VAT applies, it’s more likely to be contractual arrangement, therefore funds are unrestricted.

Looking at grants and contracts there are some clear differences. With grants they are a gift given freely by the donor where goods and services are not received in return; whereas with a contract there is an agreement between two parties and a direct link between consideration and service.

Grants are covered under the trust law legal framework; contacts 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 if they fail to deliver on their agreement for damages, which could be higher than the contract value.  Also with grants unused funds can be clawed back, but with contracts surplus 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 to 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 of the budget then typically it is restricted
  • and if the donor requests an audit/accountant’s certificate at the end then it’s 100% restricted.

The key is the T&Cs and charities must read the small print. It’s very important that the programme / finance team identify when a restricted fund is received to be able to account for it accurately.

Income recognition

There are three golden rules of restricted grants and donations – entitlement; measurement and probability (ie 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 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 it’s recognised when the conditions are met.

The webinar includes lots of examples to illustrate these points. One example is the charity has applied for £12K to buy a mini bus, when does the charity recognise the income? It’s when they receive the letter saying the grant has been awarded. It should not be deferred until the mini bus is purchased. This is because once the funding is confirmed, the charity has control of when the purchase can be made.

Management of restricted funds

The general principles are as follows:

  • charities must have systems and controls to ensure the funds are spent on purposes the funds are given for and that it can be monitored,
  • it is recommended they use separate project codes/cost centres in the accounting system where possible; or keep the records on another database e.g. Excel if the accounting system has limited functionalities to set up project codes, though it adds on the complexity of the record keeping,
  • direct expenditure should be identified – staff costs, other purchases
  • and they 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. Elements of restricted expenditure include staff costs, invoices and overheads.

Charities should 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 then permission must always be sought from the funder.

For more information on restricted funds, watch the webinar by clicking here.

Sayer Vincent also recommends further reading:

  • Charity SORP 2015, by clicking here
  • Sayer Vincent’s Made Simple guides on SORP 2015 and Grants and contracts, by clicking here

Vivien Ma is senior audit manager for Sayer Vincent.