Focus on what counts

Challenges in Evaluating Reasonable Methodologies for Allocating Expenses by Functional Category

November 11, 2015
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By Steven Glickman

Functional Expense Overview
Functional expense allocations can be challenging for not-for-profit organizations when expenses must be divided among various operations. U.S. not-for-profit organizations are required by accounting principles generally accepted in the United States of America (“GAAP”) ASC 958-205 to report expenses based on functional classifications. This information can be included either in the statement of activities, statement of functional expenses, or notes to the financial statements. Additionally, a breakdown of functional expenses is required on Part IX of Form 990.

As opposed to natural classifications, which explain the actual expenses incurred by an organization (salaries, insurance, rent, etc.), the allocation of expenses by functional category are classified according to the purpose for which the costs are incurred. The most common functional categories used for not-for-profit organizations are:

  • Program services – costs incurred that are directly associated with the organization fulfilling its mission
  • Supporting services
    • Management and general – costs incurred to run the operations of an organization that are not directly associated with a specific program, fundraising, or membership development activity
    • Fundraising – costs incurred to solicit or secure contributions
    • Membership development – costs incurred to attract and maintain an organization’s membership base

Third parties, such as donors, creditors, and compliance departments, are common users of not-for-profit organizations’ functional expense information, and will use the information to help evaluate how effectively a not-for-profit organization is fulfilling its mission and utilizing its resources. Not-for-profit organizations may utilize their schedule of functional expenses for benchmarking against peer organizations, analyzing the use of funds in running programs, or for enhancing the organization’s reporting transparency. Typically not-for-profit organizations strive to exceed the Better Business Bureau Wise Giving Alliance guidelines that require a minimum 65% of total expenses being incurred from program service activities and the remaining 35% for supporting services.

Allocation Methodology
While some expenses can be allocated in their entirety to a single function through specific identification (direct allocation), most expenses relate to more than one function and need to be allocated among the functions benefited. Direct allocation of specific expenses is the preferable method of charging expenses to various functions. However, if specific identification is not practicable, an allocation is appropriate. The allocation methodology utilized should be reasonable, consistent, and periodically reviewed and challenged. Objective methods of allocating expenses are preferable to subjective methods and allocations may be based on related financial or non-financial data. Common allocation metrics include time and effort, direct costing, and usage of space (i.e. square footage).

Despite existing guidelines, allocating expenses can be a challenge for an organization. Common errors found in functional expense reporting include:

  • Reporting all expenses as program services
  • No allocation of personnel costs among functional categories
  • Reporting contribution revenue with no fundraising costs
  • No allocation of insurance, occupancy, and depreciation
  • Charging all accounting and legal fees to program services
  • Using a fixed percentage to allocate costs rather than on a systematic and rational basis
  • Lacking consistency in reporting of functional expenses between audited financial statements and the 990 return
  • Waiting until the end of the year to allocate costs by functional category as part of the annual audit preparation, instead of evaluating the allocation methodologies throughout the year

As is apparent from the list above, there are challenges to reporting of expenses by functional category. Not-for-profit organizations are often dealing with limited information and outdated time entry systems so maintaining quarterly and annual financial reporting on a functional basis can be difficult as a result of these limited resources. Not-for-profit organizations should maintain proper documentation to support the allocations including, but not limited to:

  • Details of the allocation method(s) used for classifying expenses that relate to more than one functional category
  • Rational for selecting the allocation method(s)
  • Worksheets supporting the actual calculations used to allocate the expenses

Not-for-profit organizations should implement procedures for allocating functional expenses and maintain policies to enable appropriate allocation of expenses by functional category. Furthermore, procedures cannot be static. Not-for-profit organizations should review their procedures and policies on a regular basis to assure that they are yielding accurate information.

For more information on implementing procedures and policies related to the allocation of expenses, please contact Not-For-Profit Practice Leader Adam Reiss.