UK: PULSE - Quarterly Newsletter Of Deloitte’s Charities And Not For Profit Group - Summer 2012

Planning for the future of UK Generally Accepted Accounting Principles ("UK GAAP")

By Phil Lenton

In January 2012, the Accounting Standards Board ("ASB") published its revised proposals for the future of financial reporting in the UK and the Republic of Ireland in the form of three exposure drafts:

• FRED 46 'Application of Financial Reporting Requirements' (draft FRS 100);
• FRED 47 'Reduced Disclosure Framework' (draft FRS 101); and
• FRED 48 'The Financial Reporting Standard applicable in the UK and Republic of Ireland' (draft FRS 102).

FRED 46/FRS 100 sets out the revised accounting framework including which accounting standards to apply, when an entity should comply with a Statement of Recognised Practice (SORP) and certain transitional arrangements. FRED 47/FRS 101 will not be applicable to charities as it introduces a reduced disclosure regime for members of a group that are preparing accounts under full IFRS.

The main standard that will be most relevant to charities is FRED 48/draft FRS 102. This standard replaces all current UK financial reporting standards with a single Financial Reporting Standard based on the International Accounting Standards Board's (IASB) IFRS for SMEs. It also sets out a reduced disclosure framework for members of a group preparing accounts under that standard.

Changes from previous proposals

The ASB have proposed extensive amendments to the three tier reporting framework contained in its original proposals. These amendments have made the revised proposals closer to current UK GAAP and include:

• the concept of 'public accountability' has been eliminated and there is no mandatory extension of the scope of full IFRSs. This means that the very few charities that would have been deemed to be publicly accountable, such as those with listed debt, do not have to apply full IFRSs. In addition, pension schemes will not have to apply full IFRSs, although there will be enhanced disclosure requirements for financial instruments;
• the separate guidance on public benefit entities has been incorporated into the main standard and areas that apply only to public benefit entities, such as the treatment of donated goods, are prefaced with "PBE";
• a number of options that existed under current UK GAAP, such as the ability to revalue fixed assets, have been restored;
• accounting treatments under current UK GAAP for which there was no equivalent in the IFRS for SMEs have been incorporated, such as the accounting rules for heritage assets; and
• there have also been changes to align with EU law, such as in relation to the requirement to prepare group accounts, and where the treatment in the IFRS for SMEs was thought to be not suited for use in the UK, such as in relation to taxation.

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Full details of all of the changes are available on the Financial Reporting Council (FRC)'s website www.frc.org.uk/Our-Work/Codes-Standards/Accounting-and-Reporting-Policy/The-future-of-UK-GAAP.aspx. Deloitte ukGAAP Alert also provides further details www.deloitte.com/assets/Dcom-UnitedKingdom/Local%20Assets/Documents/Services/Audit/ukGAAP%20Alert/uk-audit-ukgaap-alert-january2012.pdf.

In respect of charities, the revised proposals contain some inconsistencies in respect of funding commitments and also appear to have confused the definitions of restricted income and performance conditions. We expect these issues to be resolved when the final standards are published.

Key impact on UK charities

There a number of areas where charities will be impacted by the revised proposals, including:

• Income from donations – the previous proposals required all donated goods to be included as income from the date of receipt, as opposed to the current treatment of only recognising the income once the goods were sold. The original proposals met with considerable opposition from the charity sector and the revised proposals allow charities more discretion over when to recognise the income based on whether it can be reliably measured and whether the benefits outweigh the costs.
• Investment revaluations – listed investment and investment property revaluation gains or losses will be included with other income and expenditure and not shown at the bottom of the SOFA in other recognised gains and losses.
• Financial instruments – derivatives will be shown on the balance sheet at fair value. Pension schemes – the treatment of pension scheme movements in the SOFA will change. There will also be no multi-employer exemption for entities under common control.
• Cash flow statements – all charities preparing accounts under the standard, regardless of size, will have to prepare a cash flow statement unless they are part of a larger group.

Subsidiaries of charities will also benefit from a reduced disclosure regime, such as not having to produce a cash flow statement, not disclosing key management compensation or capital commitments and having reduced disclosures for financial instruments.

The FRSSE (Financial Reporting Standard for Smaller Entities) will continue to apply and so charities that prepared their accounts under the FRSSE can continue to do so.

The Charities SORP will be revised to give more guidance on accounting treatments under the new standard.

Next steps

The consultation period for the latest proposals ended on 30 April 2012 and it is expected that the final standards will be issued later in 2012 once the FRC has reviewed the responses to the consultation. The new accounting regime is expected for apply for accounting periods commencing on or after 1 January 2015. This would mean that for charities with a March year end, the first accounting period to apply the new standards would be the year ended 31 March 2016. Early adoption is permitted in the draft standard, but in respect of charities this will only be possible once the revised SORP has been issued by the Charity Commission/OSCR.

What now for public benefit?

By Jonathan Brinsden

On 27 June the Charity Commission issued revised draft public benefit guidance for public consultation. The consultation is open for 3 months, closing on 26 September 2012. The Commission has said that it will review its supplementary guidance for charities for the relief of poverty, advancement of education and advancement of religion in the light of this consultation. This follows the withdrawal on 21 December of its guidance on public benefit and fee charging, as well as certain elements of its other public benefit guidance, after a decision of the Upper Tribunal on 2 December, which would have quashed those elements of the guidance had they not been withdrawn. What practical effect might this have for charity trustees?

Why does the guidance matter?

Charity trustees are under a statutory duty to have regard to the public benefit guidance when exercising any powers or duties to which it is relevant. Clearly, therefore, it would not be satisfactory for charity trustees to have regard to guidance which the Upper Tribunal has found to be flawed. For this reason, the public benefit guidance relating to fee charging has been withdrawn in its entirety, while all the other public benefit guidance has been amended to remove parts which the Upper Tribunal found to be wrong or misleading, or where references to such parts were made. In particular, an element of one the Commission's principles of public benefit, principle 2b (suggesting that the opportunity to benefit must not be "unreasonably restricted" by ability to pay any fees charged) was "wrong". The amended guidance stands, and is subject to the statutory duty, until replaced or supplemented by revised guidance following the consultation.

How might the guidance change?

The draft guidance is in a completely different format to its previous incarnation and it is too early to say what further revisions will be effected as a result of the consultation. Whilst inevitably commentators will focus upon the elements which concern the charging of fees by charities, all the original guidance was affected to some extent.

The draft guidance attempts, with varying degrees of success, to reflect the key issues arising from the Upper Tribunal decision, namely:

• A recognition that the Charities Act 2006, including the supposed removal of a presumption of public benefit for certain heads of charity (relief of poverty, advancement of education/religion), did not change the law of public benefit; A recognition that the principles of public benefit apply only to the purposes of a charity, not its activities – the Upper Tribunal was clear that the activities carried out by a charity in pursuit of those purposes have no bearing on whether or not its purposes are for the public benefit; an institution's status as a charity "depends on what it was established to do not on what it does" – a crucial distinction still not fully grasped in the draft guidance;
• A statement that how a charity carries out its purposes is a matter of judgment for the charity trustees, acting within their purposes and their duties as charity trustees:

• A clearer explanation of what the "poor" can mean in this context, e.g. it will depend upon the context, it does not necessarily mean destitute but can mean those of "modest means", the "not very well off" or, even in very limited contexts, the "quite well off".
• A move away from a "totaliser"-style attitude of what "benefits" may "count" for public benefit purposes, and whether a particular level of benefit for the "poor" is required or met, towards instead the question, as put by the Upper Tribunal, of "whether the trustees are acting consistently with their obligations".

What do charity trustees do in the meantime?

As noted above, the revised guidance stands as the Commission's guidance, to which charity trustees must have due regard under the statutory duty. Charity trustees have the reassurance, which itself carries a responsibility, arising out of the Upper Tribunal's decision, that the question of how to run their charity is a matter for them. This does not mean they have carte blanche to act in any way they wish – they are bound to pursue their charity's objects and to do so in accordance with all the duties of a charity trustee. For example, they cannot act in such a way as no reasonable trustee would act (hence the embargo on total exclusion of the poor, as it is assumed no reasonable trustee would seek to run a charity in such a way).

There is, however, no standard of "reasonableness" which trustees must meet, because it is not for the court, the Tribunal or the Commission to set such a standard. The essential question for charity trustees has always been, and remains, "What are my charity's objects and, within our resources, how can we best pursue them?".

The Upper Tribunal sought to answer questions posed by the Attorney General in relation to very specific situations regarding hypothetical educational institutions. The Charity Commission has set out the responses to those questions on its website. Charity trustees may wish to review those responses, but are not obliged to do so. It should be noted that the responses are heavily caveated, because they are views given concerning artificial and highly individual cases. They do not (quite rightly) attempt to set out any rules or benchmark and they cannot be a substitute for the proper exercise of discretion by charity trustees with the knowledge of the actual circumstances of their charity.

Longer term?

The question of public benefit had been dealt with by the courts for centuries without apparent controversy. There are few cases on the subject because, as the Commission's general public benefit guidance acknowledges, in most cases the question of whether particular purposes are for the public benefit "will be obvious". It is only in those few cases where it is was not obvious, that the matter ever came before the courts. On the face of it, the Charities Act 2006, and the guidance which it engendered, seemed to create a problem which previously did not exist.

The question of public benefit and the meaning of "charity" in English law are among the points to be considered by Lord Hodgson in his current review of the operation of the Charities Act 2006 (the provisions of which now appear in the consolidating Charities Act 2011) ; he is expected to present his completed review, which will consider further changes to the legal and regulatory framework for charities, to Parliament ahead of the summer recess this year.

It is too early to discern whether Lord Hodgson may make any recommendations for change, but potentially the matter could go back before Parliament in the next few years. In a world of economic meltdown and ever greater demands for diminishing resources, charities could be forgiven for hoping that the Parliament leaves them alone.

Charity Investment Strategy – understanding and applying total return

By Andrew Pitt

Charities are increasingly applying the concept of "total return" to their investments, instead of the more traditional "income-driven" approach. It is suggested that, in the current environment, a total return strategy offers many charities a more appropriate investment strategy. This article explains what total return is, and why it may offer a better alternative.

Many charities still have an investment policy that is designed to deliver the maximum income possible. This can produce a conflict as, while charities may want to maximise their income in the short term, they also need to ensure they preserve their spending power in the long term. They will only achieve the latter if the real (i.e. after inflation) value of the capital invested does not shrink over time.

From an investment standpoint, these have tended to be conflicting objectives because the asset classes that are traditionally considered to provide the most income (e.g. bonds) have generally provided the least long-term protection against the erosion of the 'real value' of an investor's capital by inflation. In contrast, asset classes that are often viewed as providing the best long-term protection (e.g. equities) have, correspondingly, tended to provide a lower level of (initial) income, although, with equity-market yields being as they are right now in most of the major economic regions, the reverse may now be the case. This has been further complicated by the emergence of "alternative investments" such as hedge funds and private equity, which do not produce income in the traditional sense (but may, of course, provide capital returns).

For many years, "income-only" distribution policies sat comfortably with the investment conditions and practices of the time. There was a general consensus in favour of equities, and company dividend policies responded to expectations of steady income growth. Charity trustees accordingly enjoyed an income stream that facilitated income-only distributions, and their investment policies accommodated the income/capital distinction without placing undue pressure on the value of their capital.

These investment conditions disguised a number of rigidities inherent in an income-only distribution policy. What challenged the status quo was the increased availability of overseas equities and, subsequently, alternative investments.

In addition, many companies began returning money to shareholders in the form of share buy-backs, rather than dividends. In most overseas equity markets, capital appreciation played a larger role in expected investment returns and income yields were correspondingly lower than here in the UK.

Alternative investments such as private equity and hedge funds generally produced (and continue to produce) no income, at least not in the form of a physical dividend. As a result, asset allocation and investment choice under an income-only distribution policy became increasingly concerned about income loss and the need to avoid putting the portfolio's sustainable distribution at risk, rather than investing for the best total return, over the long term. This led many charities to skew their investment portfolios towards asset classes that produced income, while other asset types were ignored. A number of charities continue this practice today and, as a result, invest in less "efficient" portfolios from a risk and return perspective.

Debate is growing about the extent to which it might be safe to "top up" income by distributing accumulated capital gains according to a pre-determined formula (e.g. 3% per annum of the total value of the portfolio), while preserving the real value of the fund. This has been facilitated by the Charity Commission's decision to allow charities with a permanent endowment (which traditionally would only have been allowed to spend income) to adopt a total return approach.

Charities are increasingly adopting total return strategies. The rationale for doing so is that an investment portfolio can be managed so as to optimise the return generated, regardless of whether this is obtained from dividends, interest or capital gains. With this approach it is the overall level of investment return, rather than the composition of the return that is important. This allows trustees far more flexibility when drawing up and implementing their investment strategy and enables them to consider all asset classes rather than just those that happen to produce income. The ability to diversify risk is thus greater for a charity adopting a total return approach, an attribute that should be embraced given the difficult investment environment that is likely to persist for the next few years.

In practice, a portfolio that follows a total return policy is likely to continue to produce some income. Accordingly, the amount of capital (over and above the level of income) that needs to make up the annual distribution will normally be considerably less than the fixed percentage (e.g. 3%) specified in the investment policy. Hence trustees are unlikely ever to be forced to sell a material percentage of their portfolio at a time of adverse market conditions, even if markets perform poorly over several years. As a result, the rules governing the level of total withdrawals from a portfolio should not be subject to frequent review, even in the face of large market movements in the short term.

In conclusion, a total return investment policy that is sensibly applied is a valuable tool for many charities, the main reason being that it dispenses with the somewhat arbitrary distinction between income and capital gain. Such a policy gives trustees more flexibility when drawing up their investment strategy and can improve the overall level of diversification within a portfolio by allowing for the inclusion of a wider range of asset classes.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.