By Natalie Hopkins and Chris Mennel One of the fun parts about offering auditing and accounting services to various nonprofits (that’s right, we used fun and auditing in the same sentence #accountingnerd), is getting to see the operations of different types of organizations. There are some amazing missions, people and passions in the nonprofit community. While every organization is different, there are certain parallels in the composition of an organization’s audited financial statement, regardless of size. One of those main similarities is the concept of functional expense allocations.
The functional expense allocation is the practice of allocating expenses among specific categories: programming; fundraising; and management and general, which are further broken down by their nature: wages; office supplies; professional fees; etc.
Most organizations want to drive as much money as possible toward program expenses, showing a large percentage spent on their missions. However, well-run organizations often have higher amounts allocated to management and general, and organizations focused on growth often have higher amounts allocated to fundraising. These areas are indicative of an organization’s ability to sustain long term viability and growth, and the key is ensuring the functional expense categories are reported accurately.
Why are functional expenses so important?
- Functional expenses must be included in audited financial statements for Health & Welfare organizations and are recommended for all nonprofits. A proposed accounting standard could make presenting functional expenses required for all nonprofits.
- Expenses must be reported by function in the annual Form 990 filed with the IRS, which is a public document.
- They provide insight to the organization’s board of directors, potential donors and grantors to determine how funds are being spent. This means the accuracy of the statement is very important to the organization.
Although not the only presentation format, presenting functional expenses in a separate financial statement, such as the following, is the most common method:
Management & General
|Employee wages||$ xxxx||$ xxxx||$ xxxx||$ xxxx|
|Bank fees and other||xxxx||xxxx||xxxx||xxxx|
|Total expenses||$ XXXXX||$ XXXXX||$ XXXXX||$XXXXX|
How do organizations make sure their statement of functional expenses is accurate?
More so than any other financial statement, functional expenses can be subjective because they require expenses to be allocated based on a reasonable basis. Following is the general thought process we recommend to help ensure an accurate statement:
- First and foremost, a policy that outlines how expenses will be allocated should be developed and reviewed annually. This policy should encourage ongoing allocation of expenses, rather than waiting until the end of the fiscal year to allocate all expenses. Often, organizations wait until year-end or the tax filing process (which may be several months after year-end) to consider functional expense allocations, which may make the exercise less reliable than real-time reporting.
- Next, any and all expenses that can be directly charged to one of the 3 categories (programming, fundraising, and management and general) should be recorded 100% to that category and not allocated (called specific identification).
- For those expenses affecting multiple categories, an allocation basis and methodology should be created. Wages are a common expense that must be allocated. An executive director, for instance, may spend 60% of her time working on programs, 30% on management and general activities, and 10% fundraising. It’s common to do an annual allocation of each employee’s salary in order to allocate wages. However, allocating more often will help create a more accurate statement of functional expenses, because it takes into account changes in roles and responsibilities throughout the year.
- Expenses other than wages may be allocated using another basis, such as square footage, percentage of direct costs, or actual usage. For example, building-related expenses like rent, telephone, security, and maintenance may be allocated based on the square footage that is used for each of the 3 functions relative to the total square footage of the facility.
- Finally, as with any financial process, strong internal control is critical to the accuracy of the financial statements. Internal control procedures should be evaluated to ensure allocations are being made as accounting transactions are taking place and that the account coding facilitates the creation of a statement of functional expenses.
All-in-all, functional expense reporting may seem like a small piece to the nonprofit accounting puzzle, but it is an important one. Establishing good functional expense reporting will provide transparency to your constituents and further support the integrity of your financial reporting. With watchdog organizations and donors analyzing spending, no organization can afford to publish inaccurate data. For more information on how to ensure your functional expenses are accurately classified, contact Natalie Hopkins or Chris Mennel at Alerding CPA Group, (317) 569-4181 or visit our website: www.alerdingcpagroup.com.
This post was written by:
Natalie Hopkins, CPA
Natalie services audit and assurance clientele with their annual compliance needs and general consulting services. Her client base includes wholesale/distribution, manufacturing, retail, service organizations, and health and welfare organizations. Natalie was chosen as an “Emerging Leader” by the Indiana CPA Society.
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