A Deeper Dive into Not-for-Profit Functional Expense Reporting

By Sarah Wine, CPA

As we reported in part six of our Big Changes Coming for Financial Reporting of NFP Organizations, effective for fiscal years beginning on or after December 15, 2017, all not-for-profit (NFP) entities will be required to present expenses on a functional and natural classification basis. Following is a deeper dive into not-for-profit functional expense reporting.

As many NFP organizations choose to present two years of financial statements, now is the time to start thinking about how the new standard will impact your organization. For most organizations, this will not be an entirely new exercise, as they have a statement or schedule of functional expenses as part of their financial statements.

Many other organizations, however, have only reported expenses on the Form 990. This may be the first time they will be including a functional expense statement or schedule within their financial statements.

In addition to disclosing its expenses, your organization will also be required to disclose the method used for allocating expenses among the functional classifications. This information should be included in the footnotes to the financial statements. It should also include a brief disclosure of the major types of expenses that are allocated among programs and the methodology for the allocation, such as square footage or time reporting.

Since this new reporting standard will impact all NFP organizations in some way, now is a great time for a refresher on the current accounting rules, such as the definitions of the functional classifications and common methods of allocating expenses.

We will also point out some common pitfalls, and a few tips, that will prepare you for the new standard’s implementation.

Definitions per ASC 958-720-45:

Program – the activities that result in goods and services being distributed to beneficiaries, customers, or members that fulfill the purposes or mission for which the NFP exists. Those services are the major purpose for and the major output of the NFP and often relate to several major programs.

Supporting Services are broken down into three underlying classifications:

• Management and General – the activities that are not identifiable with a single program, fundraising activity, or membership-development activity, but that are indispensable to the conduct of those activities and to an entity’s existence. These often include budgeting, oversight, accounting and record keeping, and overall management of the organization.
• Fundraising – the activities undertaken to induce potential donors to contribute money, securities, services, materials, facilities, other assets, or time. These often include any activity that is performed to induce donor contributions to the organization, including by way of special events, maintaining donor lists, meeting with or contacting donors, writing grants or contribution solicitations
• Membership Development – soliciting for prospective members and membership dues, membership relations, and similar activities. However, if there are no significant benefits or duties connected with membership, the substance of membership development activities may, in fact, be fundraising. These often include soliciting members or prospective members to become members and pay membership dues.

Allocation Methods:

• Square Feet – Costs such as utilities, rent, and building depreciation can be allocated based on the spaces the organization’s different departments occupy. For example, an organization could compare the square feet included in a lease to the square feet the development department occupies. They could then use the difference to determine the percentage of the monthly rent that should be allocated to fundraising. Next, the common area space could be allocated to all functions, based on head count. The accounting department offices could be allocated to management and general, while the space occupied by the executive director, or others who work in multiple functions, could be allocated based on how those employees typically spend their time.
• Head Count – Smaller organizations, or those that operate virtually, are typically the easiest to allocate costs based on a headcount. This is because the number of people working in each program, or supporting services, can be calculated as a percentage of total employees to allocate the underlying cost. This could also be used to allocate insurance costs.
• Time studies – Some organizations will ask their employees to document how their time is being spent during a given pay period to determine, on average, where an employee is spending their time – whether it be program, management and general, or fundraising. The organization will then use that data on an annual basis to allocate costs, such as supplies, telephone, or internet costs.
• Direct costs – Some costs only relate to one classification, such as grant payments or consulting services, for a specific program. These costs can be directly charged as incurred.

Common Pitfalls:

• Depreciation – Sometimes, organizations will include all depreciation in one function, such as management and general or program, when multiple functions are benefiting. Depreciation for building and building improvements, rent, repairs, and maintenance can all be allocated based on the square feet of the functional classification. Or, in the case of depreciation or repairs and maintenance, if the asset or repair was for a program or supporting service, the costs could be directly charged to that program or supporting service.
• Insurance – We sometimes see this directly charged to management and general. However, depending on the type of insurance, a portion of the insurance cost should be allocated to all programs and supporting services. For example, the property insurance on the headquarters of an organization which includes space for programmatic activities and management of the organization should be allocated to those functional classifications. Insurance for a site where only programmatic activities occur would be directly charged to program.
• Interest costs – Interest expense on debt is another expense we see organizations classifying as entirely management and general. Instead, the organization should allocate the cost to the benefiting program or supporting services. Since debt is usually issued for the construction or purchase of a building a reasonable allocation method could be based on square feet occupied. If costs cannot be allocated, the interest should be reported as management and general.
• Not reporting fundraising expense – If an organization shows more than an insignificant amount of contributions on the statement of activities, we would expect to see fundraising expense included in the functional expense statement. Even if your organization does not have a specific grant writer or development director, there is likely someone, such as the executive director, spending time cultivating these donations. Because that time is focused on fundraising activities, a portion of that person’s salary should be allocated to fundraising. However, there are some types of organizations that generally do not have fundraising expenses. These include religious organizations, private foundations, or an entity that has no paid staff where most, or all, contributions arise from uncompensated board members soliciting contributions.
• Forgetting netted expenses on the Functional Expense Statement – Don’t forget to allocate expenses that have been netted against revenue sources on the statement of activities, such as the direct costs of special events or costs of goods sold. These expenses can appear as a reconciling item, below a subtotal that agrees to the statement of activities functional classifications. This ties the numbers between the two statements together.
• Other/Miscellaneous Expense – As a rule, this natural expense line should not be more than 10% of total expenses.

Other Rules and Tips to Consider

• Don’t recreate the wheel – Take into consideration the functional reporting you are already performing for the Form 990. There is likely an efficient way to group some of the natural classifications to reduce the number of lines, as well as prevent additional work when preparing for your U.S. GAAP basis financial statements.
• Utilize functionality within your general ledger system – For reoccurring expenses, determine the most appropriate allocation method, calculate the allocation percentages at the beginning of the year, and set-up your accounting software to automatically allocate the expenses on a per-invoice basis. An example could be medical insurance invoices. If your organization has low turnover, the allocation by headcount can be easily calculated at the beginning of the year. An automated allocation can then be performed each month.
• Review methods on an annual basis – Like other policies, it is a best practice to review the organization’s allocation methods, at least annually, to ensure the method used accurately reflects how the costs are benefiting each functional classification.

This article should not be construed as tax advice. Before making any decision that may affect you or your organization, consult a qualified tax advisor or contact Clark Nuber.

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