Setting and meeting your association's reserve goals.

Here's how to maintain appropriate reserve levels to ensure your association's financial health.

One of the most critical factors in providing for the financial health of an association is maintaining the appropriate level of reserves relative to the organization's current and future financial obligations. Balancing resources to meet current and future obligations while providing member value is at the heart of any meaningful discussion of reserves. This concept is as applicable to trade and professional associations and their members as it is to the federal government and Social Security recipients.

When an organization is unable to meet its financial obligations over the short, intermediate, or long term, there is a devastating impact on perceived member value, staff morale, reputation of programs and leaders, and, ultimately, the organization's ability to survive. The primary reason why many organizations are "under reserved" is a lack of common understanding and consensus among association leaders as to certain basic issues:

* What constitutes reserves? Market value of investments? Amount of working capital?

* Why are reserves necessary? Why not reduce dues? Why not increase programs?

* What is the appropriate level of reserves? Investments equal to six months of expenses? Net assets equal to 50 percent of total assets?

WHAT CONSTITUTES RESERVES?

Reserves are the unrestricted net assets - unrestricted assets less unrestricted liabilities - of an organization as of a given date. Reserves are the accumulated net surpluses of the organization or the net amount the organization would expect to receive were it to sell all of its unrestricted assets and pay all of its unrestricted liabilities at a given point in time. However, because most assets and liabilities are stated at historical cost, and because associations operate on many different time horizons - seasonal, annual, five-year strategic plan - the components of an association's reserves must be analyzed, matched to the periods over which they will benefit the association, and managed to maximize their return.

Figure 1 shows a typical association balance sheet organized to reveal the components of unrestricted net assets or reserves, the reason for their accumulation, and the typical time horizon over which each component will benefit the association. Figure 2 presents a pie chart that graphically illustrates the data in Figure 1.

While many associations and their investment advisers use the terms reserves and cash and investments interchangeably, it is clear from Figure 1 that cash and investments are not the sole components of available reserves. Furthermore, it is critical to classify, available reserves pursuant to the time horizons and purposes for which they have been accumulated. For example, to say that XYZ association's operating reserves equal $150,000 - operating cash - overstates operating reserves by $110,000 (that is, $150,000 in operating cash compared to operating reserves of $40,000).

This understatement is because such a definition ignores accounts payable and accrued leave that the association has already committed itself to pay. Furthermore, defining long-term investments of $250,000 as long-term reserves ignores the association's net equity in property, equipment, and so forth and therefore understates long-term reserves by the $820,000 noted in Figures 1 and 2.

This reveals another common misconception among association leaders. The purchase of a building is not a use of reserves. An asset purchase of any kind is an allocation of reserves much like an investment allocation such as shifting from short-term Treasury bills to common stocks. However, remember that changing the asset allocation of the association's reserves will most likely affect the liquidity, time horizon, and returns associated with the underlying assets.

WHY ARE RESERVES NECESSARY?

To properly serve their members, associations must focus their strategic plans over several time horizons. Over the current operating cycle it is necessary to pay for budgeted expenses while supplementing the cashflow squeeze brought about by seasonal dues receipts and meetings income. Over the short and intermediate term, organizations must make one-time expenditures to launch new programs and provide for capital additions such as new accounting and membership systems. In the long-term, associations must ensure their ultimate existence by accumulating a source of internal financing available to temporarily cover a loss of core funding, a major restructuring, or some other significant event.

Accumulating reserves pursuant to each of these time horizons allows associations to match the programmatic needs defined in their strategic plans with the resources necessary to support them. Tracking and managing these reserves in a prudent manner demonstrates that a critical element of the board's fiduciary responsibility for sound financial management has been met.

WHAT IS THE APPROPRIATE LEVEL OF RESERVES?

Unrestricted net assets, and therefore reserves, grow by virtue of an annual positive change - through unrestricted revenues being greater than total expenses. Reserve ratios are most often expressed as a percentage of an association's operating expense budget. As noted in Figure 1, assuming a 1999 operating budget of $4.5 million, XYZ has total reserves of 27 percent - $1,210,000 divided by $4,500,000 - or three months of budgeted operating expenses. The ASAE Operating Ratio Report (ORR), 10th Edition (1997) states that respondent associations defining reserves as total unrestricted net assets with operating budgets between $2 million and $5 million set a reserve goal of 46.2 percent or 5.5 months of budgeted operating expenses.

[TABULAR DATA FOR FIGURE 1 OMITTED]

Using the ORR benchmark, XYZ is clearly under-reserved. Furthermore, only 11 percent of XYZ's reserves are allocated to operating and short-term net assets - $140,000 divided by $1,210,000 - that represent less than one month's operating expenses (that is, $4.5 million divided by 12 months equals $375,000). Long-term liquid reserves represent 21 percent of total reserves, and 68 percent of reserves are allocated to long-term nonliquid assets. Therefore, in addition to being under-reserved, XYZ's allocation of its reserves is not properly matched with the needs of its annual operating budget. So what can and should be done? Consider the following real-world case study.

ESTABLISHING RESERVE GOALS - A CASE STUDY

XYZ association received a management letter from its auditors containing observations and recommendations for improving its fiscal oversight. One such comment stated that the association's reserves had fallen from 50 percent to 27 percent of its annual operating budget over the past two years due to successive annual unrestricted deficits, meaning that total expenses were exceeding unrestricted revenue. These deficits resulted primarily from unbudgeted depreciation related to a recent expansion of facilities as well as from unbudgeted pension and other retirement expenses.

Furthermore, the association's operating and short-term reserves represented less than one month's budgeted expenses, causing bank overdrafts and the need to liquidate long-term investments in seasonal periods of cashflow shortages. Recognizing the serious risk posed by this situation on the association's financial health and the confidence level of its members, the XYZ finance committee took immediate action to remedy the situation.

The first step in this process was to review the prior-year budget against the audited results to identify and analyze the significant variances from budget responsible for the prior year's unrestricted deficits. This analysis revealed that the two items noted by the auditors were in fact to blame: namely, unbudgeted depreciation on assets purchased in conjunction with facilities expansion, and unbudgeted pension and other retirement benefits.

While the association had typically not budgeted depreciation and treated the actuarially determined cost of pension and retirement benefits "below the line," the committee quickly agreed that such items were an integral part of the ongoing cost of operations and therefore should be part of the association's operating budget. Accordingly, before approving the 1999 operating budget, the committee instructed management to provide for these items in the budget and to find offsetting revenue increases or expense reductions, or both.

The committee further instructed management to analyze the association's annual cash flow to determine the necessary level of operating and short-term reserves to avoid cash-flow problems, overdraft charges, and drawing on long-terms reserves to meet current and short-term needs. After reviewing these analyses, the committee adopted a budget and reserve policy that would provide for an operating budget - before long-term investment income - with a surplus equal to 3 percent of the association's expense budget. This annual surplus will be funded evenly between the association's short- and long-term investments to increase both short- and long-term reserves liquidity. Further, the committee agreed to propose a 2 percent membership dues increase in order for budgeted revenue to cover the full cost of operations and provide for the budgeted surpluses necessary to build reserves.

Finally, the committee agreed to recommend to the board that all investment income - both realized and unrealized - earned on long-term investments be credited to the association's long-term reserves and segregated for reporting purposes from the change in unrestricted net assets from operations. The return on long-term investments was budgeted at a conservative rate of 10 percent, consistent with the advice of XYZ's investment consultant based on the association's asset allocation, risk tolerance, and time horizon for these funds.

The board adopted the overall reserve strategy with the ultimate goal of providing for greater liquidity and creating over a six-year period a long-term reserve equal to 46 percent of budgeted annual expenses, as called for in the ASAE Operating Ratio Report. In conjunction with documenting and approving this policy, the finance committee and board instructed management to prepare a projection (see Figure 3) that would clearly illustrate this reserve goal. This analysis will be updated by management based on actual results and periodically reviewed by the finance committee and board with further action taken as necessary.

HOW MUCH IS TOO MUCH?

An association's ultimate reserve goals and strategies are not determined in a vacuum based solely on the projected financial health of the organization as benchmarked against its peers. As with all significant association decisions, setting and meeting reserve goals requires fiscal discipline as well as consensus among volunteer leaders.

In an association world in which boards turn over frequently and perception is often reality, association leaders must continually work to ensure that reserves are justified based on current and planned operations, and that this is effectively communicated and embraced by association stakeholders. One way association boards often justify reserves is by "designating" unrestricted net assets in financial statements to earmark reserves for specific purposes - operations, building, programs, and the like.

Unlike the for-profit world, where the Internal Revenue Service requires corporate taxpayers to justify or be taxed on "accumulated earnings," the IRS generally has not challenged not-for-profit organizations based on their level of reserves. The appropriateness of reserves has been viewed as a function of ensuring financial health while meeting the needs of members. However, a new proposal by the Clinton administration to tax investment income threatens to muddy the waters. (See sidebar, "Proposed Tax Threatens Investment Income.")

Prior to the administration's proposal, associations were more likely to hear from members on the subject of "excess reserves" than from the IRS. This is due to the fact that some members have the perception that any operating surpluses should be used to reduce dues, increase services, or both. This having been said, experts have generally recommended that when total reserves exceed two years of budgeted operating expenses, an association should seek IRS approval for such an accumulation.

Setting and meeting your association's reserve goals requires fiscal discipline, a clear and well-communicated plan, and a consensus among association stakeholders and their advisers. Achieving these goals will help ensure the current and future financial health and viability of your organization while meeting critical member needs.

RELATED ARTICLE: Proposed Tax Threatens INVESTMENT Income

By George Constantine 

While the prudent association executive will want to maintain substantial reserves to guard the association in times of trouble, the Clinton administration is proposing to remove the incentive to do so.

Currently, investment income from interest and dividends is not subject to tax for associations and the vast majority of other types of tax-exempt organizations. However, the Clinton administration's budget, released February 1, would tax the investment income - as well as earnings from rents, royalties, and some capital gains. earned by associations that are exempt from tax under Section 501(c)(6) of the Internal Revenue Code. This plan would have a ruinous effect on associations, which, unlike their counterparts in the for-profit world, are unable to seek money through stock offerings and capital markets.

The proposal would re-categorize investment income as subject to unrelated business income tax. Of course, the reason behind UBIT has always been to keep tax-exempt organizations from competing unfairly with for-profit corporations. This expansion of UBIT to cover an association's passive income does nothing to further that purpose - an association is not in competition with any other individual or organization when it earns interest and dividends on its investments or gets paid for licensing its name and logo.

ASAE has been working against this proposal - reaching out to its grass roots, meeting with key congressional and White House staff, and distributing letters to all members of Congress. ASAE is focusing on the adverse impact that this huge tax (estimated to bring in $1.44 billion over five years) will have on the important contributions associations make to adult education and skills training, standard-setting, professionalism enhancement, statistical research, safety programs, and community work. For more information on this proposal and how you can help, please call ASAE's Public Policy Division at [phone]; or e-mail: publicpolicy @asaenet.org.

George Constantine is staff counsel for ASAE. E-mail: [e-mail].

RELATED ARTICLE: Budgeting Unrealized Investment Gains: THE SLIPPERY SLOPE 

In 1994 the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations, which required most not-for-profit organizations to present their investments at market value as of the date of their financial statements. The significance of this statement for associations previously recording their investments at the lower of cost or market has been that, in an unprecedented bull market for stocks, associations have been earning and budgeting double-digit returns on their investments. This includes that portion of total return represented by the change in market value between reporting periods on securities held in association portfolios (in other words, unrealized gains).

While it is appropriate to credit operations with a conservative return on short- and intermediate-term funds, such as 5-7 percent, the practice of budgeting and reporting the total return on long-term investments - especially unrealized gains - as part of an annual operating budget is a slippery slope that can mask significant systemic financial management problems such as significantly unprofitable meetings and publications. These problems come into full focus during periods, such as last summer, when there is a correction in the stock market and organizations recording large unrealized losses on long-term investments to operations are sent scrambling to cut programs and overhead to make budget by year-end.

The lesson, of course, is to budget only a conservative return on operating and short-term funds as part of the operating budget, and segregate reporting of long-term investment returns from operations when preparing financial reports. This way, management can be held accountable for the operating budget that it develops and implements, and money managers and investment consultants can be held responsible for properly implementing, reporting on, and monitoring the board-approved investment policy.

RELATED ARTICLE: Critical STEPS

Associations seeking to establish and maintain appropriate levels of reserves generally encounter obstacles in one or more of the following critical steps of the process. Take the measures cited here to help prevent problems.

Establishing and maintaining board consensus. No long-term plan for an association stands a chance without establishing and maintaining consensus for it at the board level. With respect to reserves, this means you must ensure a full understanding of the member and organizational benefits of establishing and maintaining reserve policies over various time horizons, communicate the risks associated with not establishing and enforcing the policy, and ensure that such policies are not subject to change with every change in the board.

Getting member buy-in, While the board serves the overall organization and all its members, pressure from various classes of members to meet their short-term needs too often carries the day. You must communicate effectively to members the wisdom as to why the association should accumulate and maintain appropriate reserves in lieu of dues reductions or additional program spending, or both.

Defining and calculating reserves. As with many association financial issues, the lack of commonality of understanding in the definitions and calculations surrounding reserve funds often leads to avoidance or oversimplification (e.g., investments equals reserves) at the expense of sound financial policies. Educate and communicate to prevent this problem.

Establishing fiscal discipline. It is easier said than done to get association leaders to establish and monitor operating budgets that realistically project operating revenues, that do not balance themselves on long-term investment returns, and that provide for recurring net surpluses. To achieve an appropriate level of fiscal discipline, wean your association from any poor budgeting and reporting practices.

Establishing accountability. To effectively accumulate and manage appropriate types and levels of reserves, establish and monitor accountability. An investment consultant should not be held accountable for not meeting the association's operating budget goals just as a chief executive officer should not be held responsible for a correction in the stock market.

RELATED ARTICLE: ASAE's Reserve FUND GOALS

For as long as I have been overseeing ASAE's reserves - 18 years - the association has had a policy stating that "ASAE should have a reserve goal of 50 percent of its operating budget." In doing a calculation several years ago, I realized it would take ASAE 367 years to achieve this goal.

In 1997 ASAE took a whole new approach by developing a liquid reserve policy that specifically contains rationale for the development of an ASAE target liquid reserve fund. The new policy was intended to establish reserves to cover objectives that include both unanticipated circumstances and onetime or episodic situations. In establishing a target amount for each objective, a worst-case scenario was used to determine each specific reserve as stated in the new policy. The policy further stipulated that a review be conducted and target amounts adjusted at intervals not to exceed three years.

The creation and maintenance of an adequate reserve fund is a fundamental tenet of sound financial management. The purpose of ASAE's liquid reserve fund is to ensure that ASAE has the financial means to continue to provide critical support to the association management profession in both the short term and the long term.

Following are the six objectives of the reserve fund, which identify a target amount for the fund over the next several years.

OBJECTIVES

1. To sustain basic operations and core member services during a short-term economic downturn. Short-term is defined as 12-18 months.

2. To continue the operation of those activities designed as fee-for-service, which maintains strong income over expense.

3. To sustain essential member services during a transition to a long-term economic downturn. Long-term economic downturn is generally referred to as a period of time beyond 12-18 months that has more of a permanent nature than a short-term economic slump.

4. To provide a source of capital for the up-front funding of the purchase of capital expenditures. This major capital reserve would be above and beyond the normal annual capital expenditure, and would be used as a result of fire, massive water damage, and so forth, above and beyond insurance reimbursement.

5. To cover unbudgeted and extraordinary expenditures brought about by unanticipated challenges or opportunities for emergency funding, such as critical activities. Reserves addressed in this objective cover both unanticipated circumstances and one-time or episodic situations.

6. To provide ASAE with a source of capital for research and development of new products and services that have the potential to significantly benefit the association management profession.

In the past, ASAE budgeted "a commitment to reserves" in its operating budget to achieve the ASAE reserve fund goal. The reserve policy I describe here has been in effect at ASAE for three years. It was recently adjusted to reflect inflation (based on the consumer price index). The policy is reviewed by the ASAE Budget/Executive Committee on an annual basis to ensure that the total reserve fund objective is being met.

Malcolm S. Karl, CAE, is vice president and chief financial officer of ASAE. E-mail: [e-mail]. Copies of the ASAE liquid reserve policy can be obtained from Ann Marie Penaranda. Phone: [phone]. E-mail: [e-mail].

John P. Langan, a certified public accountant, is managing partner of Langan Associates, PC, Washington, D.C. He serves as vice chair of ASAE's Finance and Administration Section Council. E-mail: [e-mail].