In-depth

SORP thinking: clarity versus efficiency?

Finance | Peter Gotham | 31 Jan 2008

Peter Gotham offers a personal view on the development of the Sorp. 

In 1984, in the early days of the Directory of Social Change, Michael Norton and Luke FitzHerbert were beginning to make the world of giving by companies and trusts more transparent. Then there were the Charities Acts of 1992 and 1993, rapidly followed by Adrian Randall’s work in forming CFDG, and the first charity Sorp.

The sector was beginning to take a more structured shape and the debate was then about the balance between transparency and the prevention of malpractice set against a desire not to stultify enthusiasm and innovation. At that time the sector was voluntary – but very rapidly becoming less amateur.

A world away

It seems a world away, and in many ways it was. The sector may be as dependent on voluntary activity, but it is certainly more professional – both in terms of paying for people’s time and in terms of approach. Both the sector and commercial companies are beginning to report on plans and achievements. Larger companies now need to have an expanded business review, and while Sorp compliance covers most aspects of this, more information is needed on key performance indicators and major risks.

The sector is much more part of the mainstream with respect to service delivery, and has grown significantly in resource and confidence. There is active debate about whether there needs to be more research on the sector, including about how to measure impact, beyond the simple metric of surplus or deficit. The commercial sector is being asked similar questions, to some extent as a result of pressure from the not-for-profit sector.

There is an increasing expectation that public interest entities be consistent in their accounting approach, and this includes not just charities, but housing associations, higher education bodies, and even government bodies.

In the past all companies needed an audit – and followed the same accounting standards – whereas now smaller companies do not require an audit and can apply the Financial Reporting Standard for Smaller Entities. Finally UK GAAP is expected to become consistent with international accounting standards in the near future.

But in my view the underlying debate is still between an ideal of complete transparency and a need not to detract from the effectiveness of the sector.

In this context the publication last June of the long awaited Statement of Principles for Financial Reporting – Interpretation for Public Benefit Entities was well timed to inform the debate about how the sector and the Sorp committee should move forward. The status of the Interpretation is a bit anomalous. It is published by the ASB, the highest court for accounting standards in the UK, but para 4 states that where there is a conflict between it and a Sorp then the Sorp should be followed. I suppose this is a practical measure, and that the implication is that over time there should be convergence between relevant Sorps and the Interpretation, at the same time as the principles are informed by the development of the international standards.

The Sorp committee has decided to start a process of consultation this year and while my comments are a personal view they are informed by the papers made available to the committee, including the very useful report on the Interpretation laid before the committee’s October meeting. Most of the committee papers are available on the Commission’s website, and useful guidance is also now being published, including for smaller charities, and on the analysis of grant income.

The committee now includes two non-accountants, partly as a means of trying to ensure that the perspective of the ordinary user is reflected. I have expressed doubts over the extent to which the Sorp may have become too concerned with pursuing technical excellence, pushing the boundaries well beyond the basic requirement to comply with accounting standards. It could be that it was recognised that this viewpoint needed serious consideration, obviously within the general remit of improving standards.

Developing the background

The increasing professionalism expected of the sector has resource implications, both in terms of the time taken to address increasing regulation (even bearing in mind the Commission’s efforts to reduce that which it is responsible for) but also the expected skill level. One aspect of this that particularly concerns me is the possibility of a declining pool of willing volunteers from the accountancy profession, just at a time when their skills might be increasingly useful. There is a growing recognition by professional people of the risks of participation, and the recent extension of continuing professional development to volunteer activities could be a further disincentive. At the same time the reduction in the number of registered audit firms seems likely to reduce the pool from which volunteer accountants who have an understanding of the sector can be drawn. Set against this is the growing level of competence in the sector, and increasing accessibility of technical resources.

The sector is much more part of the mainstream, and about 1,000 charities comprising 60 per cent of the sector by asset value, staff numbers and income, are over the statutory audit threshold, whereas, by number, 99 per cent are below. This factor may not significantly influence international standard setters, certainly judging by the priorities agreed by the International Accounting Standards Board (IASB) for the planned International Financial Reporting Standards (IFRS), where there are no current plans for a FRSE equivalent (other than the proposed IFRS for Small and Medium-sized Entities which is designed for all but the largest companies), nor for a standard for public interest entities.

The Interpretation is part of a process for consistency in accounting approach. This seems likely to bring to a head some issues that have not been directly addressed. Appendix 4 identifies one particular area where the charity Sorp is not consistent with those for housing associations, or higher education bodies, and this is SSAP4 and the treatment of government grants received for capital assets. It is stated that the treatment adopted in the charity Sorp “will need to be addressed in any future development of SSAP4”, and by implication by other Sorps.

One other area that indicates the minefield that would lie ahead should IASB wish to develop an IFRS for public interest entities is that of commitment accounting. Appendix 4 identifies the treatment of patients with chronic conditions, such as diabetes, who would probably die if insulin did not continue to be provided by the state. As is said: “It could be argued that a constructive obligation has been created . . . yet such commitments are generally not provided for.” The word on the street was that the government’s commitment to provide pensions is an even bigger issue. The ASB diplomatically states that this area is one that will be explored in ongoing discussions about international accounting standards.

In this context it is easy to see why the ASB has such problems with leaving the treatment of heritage assets as anything less than a tidy set of rules. The discussion about FRED 40 rumbles on, and we await the report commissioned by the Treasury from RICS and Kingston University. The treatment of in-kind contributions, on the other hand, has been addressed in the Interpretation – but to arrive at a solution dependent on the value to the charity, rather than the cost to (some) providers. Of course in this case as well there appears to be no completely intellectually satisfying solution.

These two issues alone mean that it is impossible to say with certainty how big the sector is in terms of either asset value or income. These are also examples of the difficulty of comparing charity accounts. This leads squarely into the question of research, both into inputs (financial resource consumed) and the effectiveness with which those resources are applied. After all it is odd that for a sector that is not in the business of providing a financial return, surplus or deficit is often the only solid metric that is available.

Martin Brookes of New Philanthropy Capital (NPC) recently entered the fray with a controversial call to establish an organisation to scrutinise charities’ performance. Why should this not be universally approved of? Complaints were made that this would be “regulation gone mad”, and “going in the wrong direction”. This reaction is perhaps not surprising after years of performance management in the education and health services that has often appeared to substitute statistics for delivery, and may well have led to wasted resources, and an exodus of valuable talent from those sectors. There is also the dimension that the sector may be a recipient of public funds, but could already be said to be more regulated and monitored than comparable statutory bodies, and certainly than commercial bodies of a comparable size, including those that it is now competing with.

While the Interpretation is addressing accounting issues, and not best value, or performance, it does advance some useful criteria, in paras. 3.1–3.25, for assessing the most appropriate disclosure that I think could be usefully applied in the debate that Martin Brookes has enlivened. This is to consider the relevance, reliability, understandability, comparability (extended to consider both comparisons between entities, but also comparability between accounting periods), and clarity. However, in the event of a trade-off the ASB considers that it is likely to be best to give most weight to relevance. I think the other foundation of the ASB’s thinking was what it calls the “rebuttable assumption” that the primary user group is funders and financial supporters.

One might argue with some of the conclusions that the ASB has come to as it developed this analysis. For instance, that while the average user cannot be necessarily expected to fully understand the accounts of a particular charity, the level of technical knowledge at regulators and other intermediary bodies makes this less of an issue. It may be that this understates the extent to which members and beneficiaries might have different interests to financial supporters. It also might lead a regulator, by trying to ensure information needs are met, to forget the complexity this creates. Another factor is the importance of year-end accounts that are often, in the case of smaller charities, the only occasion on which accurate figures are available. Shared ownership of financial information is, in my view, a primary aspect of risk management and proper planning. Trustees are often reliant on the accounts to be able to fulfil their duties – including stewardship of the assets.

However, the criteria themselves would appear useful not just for the development of the accounting aspects of the Sorp, but also with respect to assessments of what scrutiny of performance is appropriate. Of course the sector might wish to revisit the criteria, and the rebuttable assumption as part of the debate about the development of the next Sorp. This would, however, require the ASB to revisit this area.

Interpretation and advancement

We also have the statement by the Sorp Committee that the primary objective of the Sorp is to interpret accounting standards. Bearing in mind the objective of advancing standards, and other regulations, such as the new Companies Act requirements, the extent to which the Sorp should go beyond these to include disclosures based on good practice in terms of disclosure about governance, social responsibility, and plans and achievements, becomes a matter of debate. Another aspect of this is whether the threshold for compliance with those aspects based purely on accounting standards should also be the threshold for any requirements that go beyond that. One consideration is that charities are subject to audit at an income level less than 10 per cent of that applying to commercial companies, but that 60 per cent by value of the sector is above the small company threshold. Is it proportionate to require smaller charities to comply as the sector develops further aspects of best practice – and can they be expected to be able to reliably comply? If not then any data may not be comparable, and any conclusions about the sector formed on the basis of an analysis of accounts could be of limited validity.

Care needs to be taken to ensure that any requirement for analysis is both relevant and reliable. An analysis of the sector’s failure to consistently apply the distinction between income in furtherance of the charities’ objectives, and voluntary income, indicates either a misunderstanding or, I think as importantly, a difficulty for charities in making the analysis both relevant and comparable, albeit that the recently published Sorp information sheet 1 has provided some useful clarification in this area. There is also the debate about the value for the smaller charity of an analysis that will be likely to necessitate significant estimates, such as the cost of generating funds, although the increase in audit threshold raises the income level at which a functional analysis is required. The costs of governance are another cost that some commentators do not consider warrants disclosure in the primary financial statements, especially for small charities where it is generally just the audit costs, plus maybe estimated overheads. One more example of part of the Sorp that illustrates the difficulty of either drawing conclusions about the sector, or indeed of comparing charities purely based on a comparison of figures in the SoFA, without an analysis of the notes, and maybe the trustee report, is the effect of different methods of fundraising.

Summary

A balance needs to be struck between the holy grail of reliable, relevant transparent information and that which is achievable with a realistic level of resource. Maybe part of this will be an acceptance that accounts should be viewed as a tool to understand individual charities, and that any detailed cross-sectoral conclusions need to be drawn with care. The committee has already decided to draft the new Sorp with the needs of small charities in mind. An idea that may be too radical would be to consider if there should be leeway on some aspects of the disclosures for medium-sized charities. That said the sector is using other people’s money, and many inside the sector agree that standards of governance should be improved.

Peter Gotham is a partner at Gotham Erskine and a member of the Sorp committee

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