In accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 958 – Not-for-Profit Financial Statements, all organizations are required to present the analysis of expenses by function and nature. The purpose of the functional expense is to present the expenses in a way that helps analyze the functional classification, such as major programs and the supporting services, but also shows the natural categories of expenses. The natural categories are items such as salaries, rent, electricity, depreciation, grants to others and professional fees. There is no requirement as to the level of detail for the natural expense categories; however, many users of financial statements note that it’s less meaningful and too much detail to have more than 15 categories. This can be presented in the separate statement of functional expense schedule, in the footnotes to the financial statements or – for smaller organizations – on the face of the financial statements. With different ways to present the information, the next question is: how are those expenses allocated?
Program service costs are expenses that an organization incurs to carry out objectives or services for various programs. Supporting activities are those that include management and general and fundraising activities, as well as any membership development activities. Per FASB ASC, glossary management and general activities are supporting activities not directly identifiable with one or more programs, fundraising or membership-development activities. FASB ASC 958-720-45 includes examples of management and general activities, which include oversight, business management, general record keeping and payroll, administration of government contracts (including billing and collecting fees and financial reporting), producing the annual report, and human resources. Examples of fundraising activities for the supporting services include the following: publicizing and conducting fundraising campaigns; maintaining donor mailing lists; preparing and distributing fundraising manuals; and soliciting contributions from individuals, foundations and others.
The reporting standards require that the financial statements disclose the specific methodologies used to allocate expenses to programs and supporting services in the financial statements. It is important to make sure that the allocation used is reasonable. The preferred way to charge expenses for various functions is by direct identification. If an expense can be specifically identified with a program or supporting activity, then it should be assigned to that function.
Many expenses, however, relate to more than one program or supporting activity, or a combination of which. This is when allocation is appropriate. The allocation needs to be rational and systematic in that it is reasonable and applied consistently over reporting periods with similar facts and circumstances. When allocating expenses to a program, there needs to be direct conduct or direct supervision of the program to be able to charge the expense to the program. One of the more common ways to allocate salary is by using timesheets. Still, you can use an estimate of employee time or an internal memo for how you allocate salaries if it is reasonable. Regarding occupancy, you can use office space by department or program as reasonable.
In addition to these examples, the following table presents other common bases for allocating natural expenses.
Once you have determined the allocation bases for expenses, you should regularly review and update them if an event occurs. Examples of events that would lead to needing to revisit the allocation include new office space or decrease in office space, new debt, starting a new program, discontinuation of programs, or changes for adding or removing staff positions. Additionally, functional classification should be analyzed by comparing the prior and current period amounts.
When looking at your functional expense and allocating natural costs per function for your programs and supporting activities, you should make sure that your policy and methodology are documented and that there is a policy in place for how it is reviewed. Internal and external reporting needs to have the methodology and rational allocation bases for all costs incurred by the organization.
BPM’s Audit and Outsourced Accounting teams are happy to have discussions and work with you on best practices and ideas. Contact us to find out more. We invite you to view our recent webinar, “Nonprofit financial statements: What do they mean?” with BPM’s Caroline McDonald and Shannon Winter to gain a better understanding of nonprofit financial statements.