Nonprofit Insights

The Basics of Functional Expense Allocation

A place for everything and everything in its place.

When it comes to your organization’s finances, the IRS certainly likes to see everything in its place. To that end, it provides specific guidance on how nonprofits should categorize expenses. Accountants have a technical term for this. They call the division of natural expenses among several functional categories functional expenseallocation.

IRS Form 990 requires nonprofits to report expenses by their natural classification ( i.e., wages, payroll taxes, telephone, occupancy) and then allocate the classifications to one of these functional categories:

•  Program Services
• Fundraising
• Management and General

Proper allocation of expenses is important. If you don’t build your accounting system around these natural categories and build in a proper allocation plan, you could face serious hurdles when it comes time to prepare your annual Form 990. Just as important, your management and board need accurate information about how much money is being spent on programs, administration and fundraising.

Donors Care, Too

Accurately accounting for fundraising and operational costs is certainly of interest to donors and other supporters, too. Nonprofit watchdog groups have “trained” consumers that organizations with low fundraising and operational expenses are more efficient and make better use of their assets. C onsumer advocates suggest that nonprofits strive to apply a high percentage of annual expenses to program services.”

Why It’s A Challenge

T he job of tagging and tallying functional expenses can be complicated. Some expenses span two or all three categories. And the guidelines for allocating expenses are open to wide interpretation — different sources recommend different practices.

For example, time spent by the executive director developing and overseeing programs can legitimately be considered a Program Services expense, yet some nonprofits place the entire director's salary into the Management and General activities function. Similarly, rent, utilities, insurance, supplies and other expenses may be fairly divided among the various functional classifications and should not necessarily be considered exclusively Management and General activities costs.

Clearly, methods of functional expense allocation vary widely from organization to organization.

Some Gernal Guidelines

In general, the instructions for IRS Form 990/990EZ provide guidance on how to allocate expenses by function. In addition, the Financial Accounting Standards Board ( FASB) Statement 117 provides additional guidance, establishing these general functional areas:

Program Services — Program expenses are those costs generated in support of activities that directly advance your nonprofit mission. In other words, these are activities that result in goods and services being distributed to beneficiaries, customers or members that fulfill the purposes for which your organization exists .

If your mission is to provide clothing for needy families, money spent to buy those clothes is a Program Service expense. On the other hand, money spent to raise donations that will eventually go to buy those clothes does not qualify as Program expenses. The same goes for funds spent to cover rent on your office. These expenses only indirectly support your mission.

Fundraising — Fundraising expenses are the costs you incur in bringing in revenue, typically (but not only) through public donations. Fundraising expenses include:

• Publicizing and conducting fundraising campaigns
• Maintaining donor mailing lists
• Conducting special fundraising events
• Preparing and distributing fundraising manuals, instructions and other materials
• Conducting other activities involved with soliciting contributions from individuals, foundations, government agencies and others
  

Management and General — This includes expenses involved in general oversight, business management, record keeping, budgeting, finance and other management and administrative activities.

Finding Your Way

Your organization will need to use these guidelines to decide for itself which expenses are legitimately program expenses and which are support expenses. The key to having any criteria you establish be accepted by auditors and donors alike is to make sure they are reasonable, justifiable and consistently applied.

Once you have established these criteria, you will need to develop a method for allocating costs among the functional areas. Some organizations use different allocation methods for different line items. For example, salaries may be allocated based on time and effort distribution summarized from periodic time sheets.

Copier, postage and telephone activity can often be allocated directly to their specific uses as well (although doing so is often time consuming). Management may also need to allocate some costs based on estimated levels of service where no other reasonable means is available. In other cases, organizations develop an indirect cost rate and allocate a percentage of expenses to each functional area.

For more information about our services to the public sector industry, Contact:
Jerry Gaither, Partner, Director of Public Sector Services at 972.448.6918.

The articles in this newsletter are general in nature and are not a substitute for accounting, legal, or other professional services. We assume no liability for the reader's reliance on this information. Before implementing any of the ideas contained in this publication, consult a professional advisor to determine whether they apply to your unique circumstances.