An analysis of expenses by function and nature tells a critical part of a nonprofit’s story. Current and prospective donors, among others, want to know how an organization uses its resources. Whether you’ve been preparing a statement of functional expenses for years or are just taking on the task of preparing such an analysis alongside your adoption of FASB Accounting Standards Update (ASU) 2016-14, Presentation of Financial Statements for Not-For-Profit Entities, don’t underestimate the importance of getting it done right. With that in mind, this article highlights common errors that can occur during the allocation process and some tips to help you avoid them.
1. Lack of Expense Allocation Methodology
The first step to a successful functional expense allocation is ensuring that the methodology is reasonable. Having a sound basis for allocation is especially important now that ASU 2016-14 requires NFPs to disclose the methods they use to allocate costs among program and support functions.
There are several approaches that may make sense, and it is reasonable (and expected in many cases) that organizations will have different allocation methodologies depending on the expenses in question. Using the square footage of a building to allocate rent expense or salaries to allocate programmatic overhead costs are just a few examples of reasonable allocation methodologies. Make sure you have a reasonable methodology that is justifiable and documented to help you prepare the required disclosures and avoid comments from your auditors.
2. Incorrect Classification of Management and General
Under ASU 2016-14, it is expected that certain costs will be solely allocated to management and general expenses because they benefit the organization as a whole. Examples of these costs including accounting, human resources, and payroll. In the past, there was significant diversity in practice, with many nonprofits over-allocating these costs to program services. Now, under ASU 2016-14, we have authoritative guidance that more clearly defines these costs. Thus, it is important for NFPs to understand the guidance and revisit their cost pools to ensure compliance.
3. Not Allocating Enough Costs to Programs
Conversely to the point above, there are often scenarios where organizations are not allocating enough expenses to program services. Job duties may change or employees may spend time on activities outside of their job descriptions. For example, human resources employees may be involved in a programmatic initiative of the organization; in that case, some of their wages and salaries can certainly be allocated to program services. Another good example lies with accounting employees. While true accounting duties are now required to be allocated to management and general supporting services, if these personnel spend a portion of their time delivering program content to recipients, then there is a reasonable basis to allocate some of their wages and salaries to program services. Taking the time to understand how your staff spend their time will promote more precise allocation of costs and ultimately, a more relevant depiction of how the organization uses its resources.
4. Ignoring Consideration of Joint Costs
Charitable organizations commonly conduct activities that have a shared programmatic and fundraising purpose (for example, direct mail campaigns, special events, and telephone solicitations). For these activities, joint costs should be considered for allocation; yet this is an area that is easy to overlook when preparing a functional expense analysis.
To get it right, organizations should first follow the guidance in FASB ASC Subtopic 958-720, Not-for-Profit Entities–Other Expenses to determine if joint costs meet the criteria for allocation. Assuming they are allocable, the next step is to ensure there is a systematic and rational basis for allocation between fundraising and the respective programmatic areas.
Some allocation methods to consider include the physical-units method (allocation of the cost of materials and activities in proportion to the number of units of output) relative-direct-costs method (allocation based on respective direct costs) and standalone method (allocation based on a ratio that uses estimates of costs for items included in joint costs had they been incurred independently).
5. Not Considering the Level of Detail in Natural Expense Presentation
There is no requirement in regard to the level of detail you present for the natural component of expenses in the functional expense analysis. Many times, organizations use 15 or more categories to disaggregate natural expenses when that level of detail isn’t meaningful to the users of the statements. Think about your audience and what will be useful to them from a materiality standpoint when disaggregating expenses. Sometimes less detail is better.
6. Lack of Fundraising Salaries Expense Allocation
If your organization has contributions, there likely are salaries associated with generating those contributions, yet so many times the salaries expense allocated to fundraising is inadequate or unreasonable. If your organization fits this profile, consider revisiting your allocation methodology. If your employees have to speak with and/or spend time courting potential donors—even if they are existing donors—then there likely should be salaries allocated to this supporting service.
7. Misclassification of Investment-Related Activity
ASU 2016-14 requires that all investment-related expenses, both direct internal and external, be netted with investment return on the statement of activities. To the extent these expenses exist, they also should be excluded from the functional expense analysis based on the new presentation requirements. Organizations should review their account groupings for their functional expense reporting and ensure these netted costs are removed when adopting the new standard.
In summary, while preparing an analysis of expenses by function and nature involves some challenging areas and professional judgment, keeping common pitfalls in mind as you go through the process should allow for an easier path to success.