In part two of this series, “How To Develop Your Nonprofit Operating Reserves,” we examined common factors that organizations should take into account when considering how much to set aside for their operating reserves. This week, let’s walk through seven steps to developing a policy to manage the use and replenishment of reserve funds.
Once an appropriate target amount has been determined for operating reserves, the board needs to draft a policy that establishes the fund and sets forth guidelines for using it. According to a whitepaper published by Grant Thornton, “establishing and documenting a formal reserves policy is a best practice that should be adopted by all not-for-profits.”
7 Steps for Developing a Policy to Manage Operating Reserves:
- Inception – Make the case for the need for an operating reserve fund to the board. NORI’s whitepaper or reserve introduction document may be helpful
- Recognition of Need – Board concurs with the case and asks finance, or related committee to create draft
- Development – Utilize tools from the Operating Reserve Toolkit (e.g. reserve ratio, outlines and sample language)
- Draft Policy – Present draft policy to Board members
- Board Feedback – Board may approve or request revisions
- Final Draft – Policy is finalized and approved
- Implementation – Put into practice the guidelines established in the Operating Reserve Policy
What strategies can we use to budget and raise funds for reserves?
There are several strategies your organization can use to budget and raise funds for your operating reserve. The most successful method usually budgets for operating surpluses annually. What the Nonprofit Finance Fund calls “chronic surpluses” is the best way to build reserve funds. Other potential strategies include:
- Include a “contribution to reserve” budget line item
- Fund non-cash depreciation expense with cash income
- Include in multi-year capital budgets
- Include as component of capital campaigns
- Include in planned giving campaigns
- Designate board contributions
- Designate staff vacancy savings
- Designate windfalls (one-time grants, gifts)
- Tariff (assign %) of unrestricted gifts to build the reserve
Nonprofit operating reserve fund basic policy components:
- Statement of Purpose and Philosophy – Put into writing the reason why your board established the operating reserve fund and state what the objectives for the fund are.
- Historical Information About the Fund – Inclusion of historical information about the fund will provide useful information for board or staff who were not present at the time that the fund was established. This will also prevent second guessing and an attempt to reinvent the wheel later on.
- Definitions – Provide definitions of key terms that are going to be used in the policy to ensure common understanding.
- Use and Replenishment of the Fund – Be clear about the use and replenishment of the fund before the need arises. This will help things go much more smoothly when the time comes. Prepare forms that ask for pertinent information and authorizations. Also make sure to determine how much can be drawn down before the fund has to be replenished, and who is allowed to do this. Thinking through the process and putting the details on paper in advance is going to help everyone follow appropriate protocol when the time comes to use the fund.
- Managing and Monitoring the Fund – Some boards allow a portion of the operating reserve funds to be invested but only in low-risk, near liquid vehicles, in order to preserve the ability to access funds quickly without penalty. Some groups actually have a separate investment policy that provides guidelines for liquidity and risk thresholds for various categories of funds. But if there is no separate investment policy, it’s a good idea to mention what the risk threshold is within the policy itself even if it’s only a paragraph or a couple of sentences.
- Role of the Finance Committee – Describe the responsibilities of the Finance Committee with regard to the operating reserve and other board-designated funds oversight.
To learn more about this topic, make sure to download the Operating Reserve Policy Toolkit for Nonprofit Organizations.
Comments (8)
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Hi Bess, this is very helpful – does a reserve fund need to be a separate account, or could it just be designated as such in our QuickBooks?
1100 State Ave
Hi Ray –
There are no rules about this, other than what an organization might adopt in its own Reserve Policy, as the funds technically remain unrestricted. That said, many organizations decide to place their reserve funds (cash portion thereof) in a separate account. That makes it easier to track the balance, and makes the borrowing and replacing process very transparent. Of course, as you suggest, diligent accounting and reporting could achieve the same end. Another reason to consider a separate account is that it could be a savings or money market account that might garner a (slight, at present) amount of additional interest income.
What is the law for non profit establishment and use of capital reserve funds
Is there an IRS regulations regarding the lenght of time to hold a reserve funds for NFP organization?
Hi Adela –
To my knowledge, there are no IRS regulations relating to reserve funds in particular. Any regulations pertaining to any other unrestricted funds/assets an organization has would apply.
Is there a specific period of time required between audits of the reserve fund for an HOA?
How does a NPO determine whether a cash and/or capital reserve fund should be created?
Thank you
Nalina Sacoor