Nonprofit entities differ from for-profit companies because they must focus on accountability, rather than profitability. With accountability comes regulations about how expenses are allocated. Expenses paid by nonprofit organizations are classified into functional expenses based on the program activity or service for which they were incurred.
Common classifications of functions include programs, administrative and general, and fundraising. Natural classifications describe the expenses by the group that describes the cost, like salaries, rent, or professional services.
In August of 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-14, Presentation of Financial Statements of Not-for-Profit Entities. The purpose of the update was to improve financial statement presentations by nonprofit organizations.
The ASU requires nonprofits to present an analysis of the function of expenses on a statement of functional expenses (SFE) or as a schedule in the notes to the financial statements within the statement of activities. The result should be a useful, transparent display of expenses that are comparable.
Nonprofit Functional Expenses Best Practices
We’ve listed some best practices for the allocation of functional expenses to keep in mind when setting up accounting procedures at your nonprofit or preparing to compile year-end financial statements.
Choose the Disclosure Method
Functional expense allocation can be done on the face of the statement of activities, in the notes to the financial statements, or as a separate statement of functional expenses (SFE). Most nonprofit organizations that have more than one program find the SFE the most effective method of recording expenses.
Whichever method is chosen, it should be decided on prior to the preparation of statements and should remain consistent from period to period.
Determine Applicable Functions
Most nonprofits can classify functions into the following categories: program services, management and general, and fundraising. The IRS Form 990 also uses these expense categories in Part IX, Statement of Functional Expenses.
Program services describe the activities that an organization engages in to further its mission. Nonprofits generally strive to have most expenses fall into the category of program services because it is appealing to donors and grant agencies. Expenses related to fundraising are not program services even though they often exist to fund the mission, however lobbying expenses can be included here if they are directly related to the nonprofit’s tax-exempt status.
Management and General
The classification of management and general is reserved for expenses that are related to the overall operations of the organization. Expenses commonly categorized as management and general include salaries, insurance, staff meetings, accounting and professional services, and other administrative expenses.
Successful nonprofit organizations strive to keep the management and general expenses lower than other functions when possible.
Fundraising expenses are incurred through the solicitation of contributions, gifts, and grants. These expenses include the efforts to collect both cash and non-cash contributions. Common expenses that appear as a fundraising expense include the postage for appeals and letters, acknowledgment letter creation, and the wages paid to the development director.
Fundraising expenses should be lower than program activity costs.
Design An Effective COA
The chart of accounts (COA) of the organization should efficiently facilitate functional expense allocation. The chart of accounts acts as the framework for classifying all transactions that occur within the organization.
The COA should be simple, flexible, and make sense with the expense functions. It should be clear when an expense code is used, which functional category the expense is allocated to. COAs can be modified and accounts added or eliminated, at any time. It is important to never delete an account that has been used in the current year.
Document Procedures For the Allocation of Nonprofit Functional Expenses
Create a written and approved functional expense allocation plan to act as a guide for expense allocation procedures. The document should include the determined disclosure method, as well as approved classifications of functions. Use the document to communicate with accounting personnel, organization leaders, auditors, and other users of the financial statements.
The plan should act as a formal document that is reviewed and updated for efficiency as often as necessary, but at least annually.
At the close of the reporting period, review functional expense classifications. Compare the total amounts in each category to prior periods. Make note of material differences, making sure that the variances make sense and can be explained to end-users.
Common variance explanations may include the launch of a new program or an unexpected large expense. The variance report can remain an internal document but should be saved for future reference.
Bottom Line For Nonprofit Functional Expenses
Allocating expenses by function is an unavoidable part of running a nonprofit organization. Properly classified and recorded functional expenses allow the organization to appeal to donors and keep their nonprofit tax-exempt status. Functional expense allocations appear on published financial statements and may be used by donors and granters, rating agencies, and even the press. Setting up an effective chart of accounts and documenting a formal allocation procedure are essential first steps for all organizations.
These initial steps set the tone for the financial reporting integrity of the organization, so don’t be afraid to reach out to a trusted advisor for assistance. Schedule a call with JFW Accounting Services and talk to one of our experts today!
Jo-Anne Williams Barnes, is a Certified Public Accountant (CPA) and Chartered Global Management Accountant (CGMA) holding a Master’s of Science in Accounting (MSA) and a Master’s in Business Administration (MBA). Additionally, she holds a Bachelor of Science (BS) in Accounting from the University of Baltimore and is a seasoned accounting professional with several years of experience in the field of managing financial records for non-profits, small, medium, and large businesses. Jo-Anne is a certified Sage Intacct Accounting and Implementation Specialist, a certified QuickBooks ProAdvisor, an AICPA Not-for-Profit Certificate II holder, and Standard for Excellence Licensed Consultant. Additionally, Jo-Anne is a member of American Institute of Certified Public Accountant (AICPA), Maryland Association of Certified Public Accountants (MACPA), and Greater Washington Society of Certified Public Accountants (GWSCPA) where she continues to keep abreast on the latest industry trends and changes.