Not-for-profits are required to report expenses by the functional classifications of program services and supporting services on the financial statements because it is required by GAAP. Additionally, they are required to report expenses by the functional classifications of program services, management and general, and fundraising on Form 990 because it is required by the IRS.
In addition to being required by GAAP and the IRS, these expenses need to be sorted because donors, funding sources, regulators, members of the board and charity watchdog organizations are scrutinizing the expenses to gain meaningful information so they can make decisions about you.
Form 990 is a public document and can be viewed by anyone online at GuideStar.com. What are people looking for? Primarily the ratio of program service expenses to total expenses and perhaps to a lesser extent, the ratio of fundraising expenses to total contributions. They want to make sure you are worthy of receiving their money.
Of course, you want your ratios to be “good,” which is generally defined as the higher the program services percentage, the better; however, it is even more important for your numbers to be accurate, consistent and reasonable. It may be more helpful to compare your organization to a similar organization than trying to figure out what the “right” ratio is. For example, some organizations have large numbers of volunteers while others rely more on employees to carry out their mission. Some organizations serve thousands, whereas others serve hundreds. If you are comparing your ratios to another organization, try to find one that is comparable in both size and scope.
Auditors are aware of the incentive to over-report program service expenses, making a thorough review of functional expenses an important audit issue so that those who view Form 990 do not reach flawed conclusions based on misleading or inaccurate information.
How to Allocate Expenses to Multiple Categories
Some expenses can be specifically allocated to a single category, but most need to be allocated across categories. There is no specific GAAP that defines methods for allocating indirect costs, but there are a couple of common methods that result in reasonable and objective allocations.
A time study of the organization’s activities from the prior year could be made at the start of every new fiscal year to determine the allocation to program, management and general and fundraising based on the percentage of time spent on each function by each person by reviewing paper or automated time-tracking systems. If these are not maintained daily, then periodic time records can be kept for employees who work on more than one function, which can serve as the basis for allocations. You can keep these records for test periods of time (e.g., a week or month), then reevaluate the allocations periodically to see if the time study needs to be repeated. Employee-related costs such as payroll taxes and benefits can be allocated on the same basis as salaries. Maintain your documentation of the time study in case questions arise.
Another common allocation method is based on square footage. This is most often applied to rent, utilities and maintenance types of accounts. You will need to determine what percentage of your total square footage is used for the program, management and general, and fundraising, and then apply these percentages to your expenses. For example, if you are a school, you could determine either by reviewing floor plans or by actual measurement what percentage of the building is occupied by classrooms, administration staff and development staff, and then apply those percentages to program, management and general, and fundraising expenses. Again, maintain your documentation of the square footage calculations in case questions arise.
You can also:
- Study the use of stationery, supplies and postage and allocate them based on the study.
- Allocate telephone expenses on the basis of use by extensions.
- Allocate automobile and travel expenses on the basis of time reports of the employees involved.
- Develop a functional expense process, backed by policies and procedures, including review by management, to substantiate your allocations.
If you want more information on cost principles, you may find OMB Circular A-122 helpful.
We’ve reviewed the why and the how of functional expense allocation. We’ve also focused on “good” ratios and “right” (or lack of there being “right”) ratios. While you may or may not be happy with your ratios, you are most likely satisfied with the efforts you’re taking to achieve your mission, I’d like to leave you with a final thought: What if, in addition to achieving accurate, reasonable and consistent functional expense allocations, you also placed more emphasis on publicizing how well you are carrying out your mission and purpose?
Potential donors and funding sources should be educated on your mission, how it is accomplished, and most importantly, why the organization believes so strongly in achieving its mission. Not-for-profits exist because someone cared enough about achieving a mission that they started an organization to carry it out.
If you have additional questions about functional expense allocation and your not-for-profit, contact Anna Williamson at 312.670.7444.