Understanding SORP

The basic framework of the Statement of Recommended Practice

Introduction
Evolution of the Statement of Financial Activities (SOFA)
Disclosures
Reasoning
Format
Presentation of the Balance Sheet
Fund Accounting
Important Points
Incorporated charities and Companies Act 1985
Further Resources

This section deals with understanding the basic framework of Accounting and Reporting by Charities: the Statement of Recommend Practice (SORP). It is not intended to provide detailed guidance to the preparation of the Annual Accounts: that is the role of the organisation's accountants. The SORP has been revised twice since it was first published, the latest revision was in 2005.

A voluntary organisation's accounts, like those of a commercial concern, have two main elements:

A statement showing the income, and what has been spent in order to earn that income. In a commercial organisation this is called a "Profit and Loss Account". Non-profit organisations used to produce something very similar in format, but called it an "income and expenditure account". This was replaced by the Statement of Financial Affairs (SOFA) in 1997 and is dealt with in more detail below.
A balance sheet - This shows the assets and liabilities of the organisation at a particular point in time - the accounting date.

Evolution of the Statement of Financial Activities (SOFA)

The traditional income and expenditure account treatment had for some time led to complaints that it did not reflect or fully explain all the financial activities of the charity. Therefore, it was considered that the very nature of the raising and using of charity resources required a different approach from that of the business community.

Charities, even those that are companies, do not usually have shareholders, so such matters as distributable profit (dividends) do not arise. Moreover, those who provide the resources for charities do not usually expect a direct monetary return on their donations. However, the users of a charity's financial statements do need to be able to assess the services that the charity is providing, primarily through its charitable expenditure and its ability to continue to provide those services.

The accounts should also show how the trustees have carried out their duties and ensured that their responsibilities have been met during the year.

Charities, except those that are effectively trading, are not usually in the business of directly matching income and expenditure. Therefore, they are not working towards a particular year end date. In other words, to place undue emphasis on the surplus or deficit at a particular point in time can be misleading as income and expenditure in any one period are not often directly linked; for example, grants received this year may be for projects to be carried out in the following year or indeed over a number of years.

Furthermore, the traditional income and expenditure account does not always adequately explain a charity's activities. Businesses primarily invest in fixed assets to generate future profits whilst, of course, a charity may be investing in fixed assets as part of its charitable activity (primary purpose), for example equipping a cancer research laboratory, building an old people's home, acquiring lifeboats, building kennels. This difference is extremely important to certain charities where a significant proportion of their annual expenditure is of a long-term nature.

In any particular year a charity may use part of its income to purchase fixed assets for its charitable activities and since this expenditure is of a capital or long-term nature it will not be shown in the income and expenditure account. This could therefore lead to a surplus on the income and expenditure account and give a misleading impression, as the cash would still have gone out of the organisation, possibly leaving a dangerously high overdraft. Therefore judging the charity on the "bottom line" - that is, surplus or deficit for the year could be misleading where there is significant charitable objective spending of a capital nature.

Disclosures

One of the main recommendations of the SORP is the statement of financial activities (SOFA). This is a way of showing, in summary form for the year

all the charity's funds
all its incoming resources
all its revenue expenditure
all transfers between funds
all recognized and unrecognized gains and losses on investments and
how the fund balances have changed since the last balance sheet date

This comprehensive primary accounting statement should show all the funds the charity has and how they have been used. Notes are required following the publication of SORP 2005 to supplement the information included on the SOFA. The notes will include further information on income, cost allocation and specific expenditure items.

Reasoning

The SOFA recognizes that charities do not usually have just one single indicator of performance which is comparable to the bottom line for business. As well as considering the changes in the amounts of the net resources of a charity, it is important to consider the changes in the nature of those resources. As a result, both the SORP and the regulations recommended a primary statement that records the resources entrusted to a charity and reflects the financial activities thereof.

The SOFA is effectively divided into two parts:

statement of operations
statement of other changes in net assets

However, many charities' accounts show that the distinctions based on operations tend to be somewhat arbitrary. They depend on the impossible task of trying to match a charity's income and expenditure when, as we have seen, often no such match is possible or even desirable. Therefore, the SOFA moved away from giving undue emphasis to the "bottom line" based on matching, and dropped the use of the words surplus and deficit.

Format

A columnar format is required by SORP 2005 and this format has been required since SORP 1995 was issued.

The minimum required is:

one column for unrestricted funds, (See 'Fund accounting' below)
one for restricted funds
one for permanent endowments and
one for the total for the year
one showing the comparative total for the previous period: it is not a legal requirement to have to show comparatives for each type of fund.

Where there have been no movements in any particular fund or the charity does not have that type of fund, then it is not necessary to include that column. Columns only need to be included where the actual funds exist and there has been movement on them.

This columnar approach can be expanded. For example, unrestricted funds can be split between general purpose funds and other unrestricted funds. If too much detail is put in, though, there is a risk of overwhelming the reader with figures and information, so they end up not being able to see the wood for the trees.

The 2005 format requires standard headings for each row such as:

Incoming resources including incoming resources from generated funds, incoming resources from charitable activities and other incoming resources.
Resources expended including costs of generating funds, charitable activities, governance costs and other resources expended

which has helped to make charity accounts more comparable. Again, as the SORP makes clear, this information will always be required, but if there has been no movement on a particular heading in the year or previous year then that heading need not be included.

Functional classification of expenditure means expenditure should no longer discloses by type on the face of the SOFA. For example cost centres such as rent, rates, light and heat and salaries should not be used.

Instead, expenditure should be described by its nature, such as:

charitable activities
cost of generating funds
governance costs.

This helps the reader to understand what the charity is doing and how much it is spending on these particular activities. Further information should then be given by way of notes to the accounts.

Finally, the SOFA encompasses a statement of gains and losses. This covers all gains and losses on investment assets (i.e. both realised and unrealised). It only covers realised gains and losses for tangible assets. "Realised" means that cash has been received - or, at the very least, legal ownership has passed and there is a legally binding contract (so the organisation can sue for the money if it has to).

Presentation of the balance sheet

The funds of a charity should be grouped together in the balance sheet according to their type, distinguishing between:

endowments
other restricted funds
designated and other unrestricted funds
(In the case of a company limited by guarantee a revaluation reserve may also be required)

as the SORP itself explains. Further analysis of major individual funds needs to be given, if appropriate, in the notes to the accounts.

The assets of the charity should be analysed in the balance sheet between fixed and current assets. The fixed assets section should show separately those for charity use and those for investment.

In addition, the assets and liabilities should be analysed in a way that enables the reader to gain a proper appreciation of their spread and character.

The balance sheet must be approved by all the trustees as a body but need only be signed by one of them on behalf of all.

Fund accounting

Just as in commercial organisations, the reserves of the charity consist of

the accumulated excess of income over expenditure
the revaluation reserve, if the organisation has revalued its assets

However, unlike commercial organisations, a charity's reserves are typically subject to externally or internally imposed restrictions as to their use. This means that the reserves must be split into their component elements or funds. These funds must be accounted for separately according to the restrictions attached to them. This is called "fund accounting" and is a fundamental concept underlying charity accounts. (Solicitors have a similar system whereby client cash has to be separately identifiable from office cash.)

The charity SORP defines a fund as:

"A pool of resources, held and maintained separately from other pools, because of the circumstances in which the resources were originally received or the way in which they have subsequently been treated."

A fund will be either a restricted fund or an unrestricted fund.

Restricted funds are funds subject to specific trusts or conditions imposed by the donor and binding on the trustees:

The conditions may be stated expressly by the donor or maybe implied, as in the case of money sent in response to a special appeal
These funds represent unspent income or assets, the use of which is restricted
Permanent endowment is a particular form of restricted fund, in that the fund must be held permanently; although the assets in which it is held may change from time to time

Unrestricted or general funds are funds, which, as the name suggests, are not subject to externally imposed restrictions. Provided that they are used in pursuance of the organisation's objectives, and in a way which is consistent with their charitable status, their use is at the complete discretion of the trustees. They are generally used for day-to-day operations.

A designated fund is a particular form of unrestricted fund consisting of amounts of unrestricted funds which have been allocated for specific purposes by the charity itself. The use of designated funds for their designated purpose will remain at the discretion of the trustees. Consequently, although they may be separately disclosed they should be grouped with the general or accumulated funds in the published accounts. They should not be confused with restricted funds. Strictly funds should be designated before the end of an accounting period and their use documented by the Board.

Important points

The trustees of the charity will be in breach of trust if they use restricted income in a way which is not consistent with the restrictions imposed.

It is essential that items of income and expenditure are added to, or deducted from, the appropriate fund.

It is also important for the trustees to ensure that the assets and liabilities are held in a fund consistent with the fund type. If a fund which, because of donor restrictions, must be used in the short term (for example, emergency famine relief) is represented by assets which can only be used in the long-term (investment in property, for example) it is possible that the charity will not be able to meet the restrictions.

There is no longer any need for the charity to open separate bank accounts for each fund, provided there are proper accounting procedures in place that identify the balances on eachfund at any point in time. This may affect the choice of any computerised book-keeping systems chosen.

Incorporated charities and Companies Act 1985

Over the last five to ten years a large number of charities have moved their charitable activities into a company limited by guarantee. Charities constituted as a company limited by guarantee also need to take into account the additional reporting requirements of the Companies Acts.