Allocating Functional Expenses for Nonprofits

The changes introduced by the Financial Accounting Standards Board (FASB) in 2016 had a profound effect on how nonprofits prepare their financial statements. In particular, ASU 2016-14 stipulates that nonprofits should report expenses in a way that reflects how they were incurred. The implication is that nonprofit organizations have to categorize expenses by nature and function.

Nonprofits now classify functional expenses into the three groups: general and administrative, program services, and fundraising. This classification is consistent with the provisions of the IRS form 990.

Program Services

Program services include all the costs of running a program that helps achieve organizational goals. It is common for nonprofits to allocate most of their expenses to this category, as donors prefer the organizations they fund to spend most of the donations on programs. The only exception is a newly formed organization because most of its expenses may go to administrative and fundraising activities.

General and Administrative

General and administrative expenses are all those costs that go towards running the organization on a daily basis. Expenses include wages, benefits, accounting, insurance, and governance. These expenses are critical to the normal functioning of the organization. However, they have no direct relationship with the vision and mission of the organization. For this reason, donors prefer to fund organizations that reduce general and administrative costs to a minimum.

Fundraising

Fundraising is a core function of most nonprofit organizations. The costs include all expenses resulting from appeals for financial support. Some of the most common fundraising expenses include compensating program directors, postage mail for funding appeals, and printing costs for different documents used in mobilizing funds. Most donors prefer to fund or make contributions to organizations with minimal fundraising expenditure.

The Standard Requirements

Nonprofits should have a clear and justifiable methodology for allocating expenses - one that is in line with ASU 2016-14 requirements. In the past, organizations tended to allocate administrative and management costs to programs. However, ASU 2016-14 requires these costs to be stated explicitly. Therefore, nonprofits need to ensure that all their management and administrative expenses fall under general and administrative functions rather than program services. Managers and board of directors should review these cost pools to ensure compliance.

Nonprofits sometimes run programs concurrently such that routine administrative activities combine with fundraising programs. In such cases, the programs have joint costs that need to be shared between different functions. They should follow the provisions of FASB ASC Subtopic 958-720, which asserts that joint costs should meet the guidelines for allocation. There are several allocation methods that an organization can use, such as physical units, relative-direct-cost, and the standalone method.

Most organizations fail to allocate sufficient expenses to fundraising initiatives. Organizations should be sure to appropriately apportion these expenses (salaries, contingencies, etc.) to reflect their true cost. For instance, if employees spend much of their time soliciting funds from or engaging with existing donors, the time spent should be allocated a monetary value.

The ASU 2016-14 requires all expenses related to investments to be included in the statement of activities and netted with investment return. Such expenses should not be included in the functional expense analysis in line with the latest presentation requirements.

The Best Practices

It is advised that nonprofits follow best practices when allocating functional expenses.

• Create a functional allocation plan and save it as a document. Ensure that the methodology you use for allocating expenses is clear and easy for accountants, administrative staff, and board of directors to understand it. It should also be easy for auditors and regulators to review your financial statements.
• Develop a chart of accounts that will help increase efficiency in the allocation process. Make sure the chart of accounts is simple, flexible, and adaptable to different accounting needs.
• Differentiate expenses that apply to one functional category from those that apply to several categories. Further, if the organization has multiple programs, make sure that each program is allocated the corresponding expenses. Accurate allocation of expenses facilitates grant reporting and makes it easy to assess the effectiveness of each program.
• Create and record timesheets for staff members who serve in different capacities in multiple programs or functional categories.
• Be consistent in making functional allocations by ensuring that all who handle the organization's accounts follow the same protocols. This will reduce inconsistencies and confusion when making financial reports.
• Review the expense allocation methodology regularly. Reviews are especially important in cases where the source of funding changes, or there is a change in the duties allocated to different employees.

Conclusion

It is important for nonprofits to remember the different groups that read financial statements and prepare reports that satisfy all parties. The most common readers are donors, the board of directors, the media, and rating agencies. Every group has its interests, but they all want to see whether the organization is successful in using resources prudently to fulfill its objectives. Lutz can help you spark the right solutions through expert accounting, staffing, and financial services. Contact us if you have any questions.