*Over the past fifteen years, there has been more pressure on nonprofits to conform to the expectation set by stakeholders to keep overhead expenses (supporting services activities) down and therefore maximize the use of unrestricted and temporarily restricted funds that can be used on programmatic activities.

The Internal Revenue Service (IRS) requires that nonprofit organizations allocate their expenses on their Form 990 into three categories: Program, Management/General,
and Fundraising. However, generally accepted accounting principles allow for costs to be allocated by program service and supporting service categories with multiple functional areas in each category.

The vast majority of nonprofit organizations allocate costs directly to the function, which is the simplest and most transparent technique. A few use indirect cost allocation methodologies for some or all of their expenditures by entering all their expenses into one or more cost center or categories (know as an overhead pool), and then reversing out the expenses based on an allocation methodology to other functional categories.

The main reason for wanting to understand a nonprofit organization’s expense structure is to understand the cost related to the activities that allow the nonprofit organization to carry out its mission. Each nonprofit organization is very different in how it accomplishes its mission and performs it programmatic and supporting services activities. In some cases these differences are cultural and in other cases they are structural related to how the nonprofit organization was originally set up and formed. Additionally, over the past ten years, there has been push back from many funders on paying for supporting services. In some cases, some funders have either paid for a very small percentage of supporting services or not paid for supporting services at all. Not recapturing the cost related to supporting programmatic services can be shortsighted and can in some cases cripple nonprofit organizations and make them not only inefficient but ineffective.

The reason for this is that it is hard to raise funds that are unrestricted and can be used for general operating activity. If all funds raised are applied directly to programmatic activities, it will still have to be determined as to where the funds will come from for the childrens’ after school program supplies; facility management (including janitorial work, repairs and maintenance); and the accounting and reporting of the program to funders. Supporting programmatic activities is important, but a certain amount of supporting services are required for an organization to be in good operating order.

Functional Expense Categories

Programmatic Activities
The number of functional reporting categories for programmatic services varies by nonprofit organization according to the nature of the services rendered by the nonprofit. There is no specific limit to how many categories a nonprofit can have. A nonprofit may only have one functional classification and that may adequately portray their programmatic activities. However, in most cases, a nonprofit will have several separate and identifiable programmatic services that relate to its mission, goals and objectives of the nonprofit. The reason for functional reporting is to provide funders and other readers of the financial statements information on how funds have been expended to provide services to participants or beneficiaries.

A nonprofit organization may also have various kinds of supporting service activities, such as management and general, fundraising, and membership development. A single functional reporting classification is usually not adequate to portray each kind of supporting service that a nonprofit may have. A nonprofit organization will have at least management and general and fundraising supporting services but it may have others depending on how the nonprofit organization’s structure is set up. It would be extremely rare for a nonprofit organization not to have fundraising expenses. Some nonprofits show disaggregated information for each kind of supporting service. For example, fundraising expenses and the corresponding support that is obtained may be reported separately for each kind of fundraising activity undertaken, either on the face of a statement of activities or in the notes to the financial statements.

Management and General Activities
Management and general activities are activities that are not identifiable with a single programmatic or supporting service (i.e., fundraising, or membership-development activity) but that are indispensable to the conduct of the nonprofit organization’s activities, mission and existence. These activities include such services as oversight, business management, general recordkeeping, budgeting and financing; soliciting funds other than contributions, such as exchange transactions and government contracts; disseminating information to inform the public of the nonprofit’s stewardship of contributed funds; announcements regarding appointments and the annual report; and all management and administration activities except for direct conduct of program services or fundraising activities.

The costs of oversight and management usually include the salaries and expenses of the governing board, the CEO of the nonprofit organization, and the supporting
staff. If staff spends a portion of their time directly supervising programmatic services or categories of other supporting services, a certain portion of their salaries and related benefit expenses should be allocated among those functions. There should never be an occasion where management and general activities are not included on the statement of activities because there are certain costs that are incurred for a nonprofit organization just to turn on the lights and open the doors every day.

Fundraising Activities
Fundraising activities are those that are undertaken to induce potential donors to contribute money, securities, services, materials, facilities, time, or other assets. The financial statements of a nonprofit organization should disclose total fundraising expenses on the statement of activities or in the footnotes to the financial statements. Financial Accounting Standards Board Accounting Standards Codification (FASB ASC) 958-720-45 provides a further description of fundraising activities, which includes publicizing and conducting fundraising campaigns; maintaining donor mailing lists; conducting special fundraising events; preparing and distributing fundraising manuals, instructions, and other materials; and conducting other activities involved with soliciting contributions from individuals, foundations, government agencies, and others. Fundraising activities include soliciting contributions of services from individuals, regardless of whether those services meet the recognition criteria for contributions in the “Contributions Received” subsection of FASB ASC 958-605-25.

Membership-Development Activities
Membership-development activities include soliciting for prospective members and membership dues, membership relations, and similar activities.

Allocation of Expenses
Some expenses are directly related to and can be assigned to a single program, service or supporting activity. Other expenses relate to more than one program or supporting activity, or to a combination of programs and supporting services. These expenses should be allocated among the appropriate functions. Examples include a direct mail solicitation that combines fundraising with program activities, salaries of persons who perform more than one kind of service, and the rental of a building used for various programs and supporting activities.

Direct Identification vs. Allocation Methods
Direct identification of a specific expense is the preferable method of charging expenses to various functions. For example, travel costs incurred in connection with a programmatic activity should be assigned to that program. If direct identification is impossible or impracticable, then an allocation is appropriate. Expense allocation techniques are utilized by all types of entities, nonprofit and for-profit alike. The reasonable allocation of expenses among a nonprofit’s functions may be made on a variety of bases. Objective methods of allocating expenses are preferable to subjective methods. The allocation may be based on related financial and/or nonfinancial data. Additionally, you may find that the guidance found in the U.S. Office of Management and Budget Circular A-122 may also be helpful in developing a methodology for your nonprofit organization to use in allocating expenses.

One misconception that lots of nonprofit organizations have is that occupying and maintaining a building is not a separate supporting service activity; however, FASB
ASC 954-720-45-25 specifically states that it is. Additionally, expenses associated with occupying and maintaining a building, such as depreciation, utilities, maintenance, and insurance, may be allocated among the nonprofit organization’s functions based on the square footage of space occupied to each programmatic and supporting service activity. If floor plans are not available and the measurement of the occupied space is impractical, an estimate of the relative portion of the building occupied by each function may be made. These costs may also be allocated based on the distribution of personnel costs or head counts.

Per FASB ASC 958-720-45-24, interest costs, including interest on a building’s mortgage, should be allocated to specific programs or supporting services to the extent possible. Interest costs that cannot be allocated should be reported as part of the management and general function.

A nonprofit organization should evaluate its expense allocation methods on a periodic basis to ensure that the assumptions used are still relevant and appropriate. The evaluation may include, for example, a review of the time records or activity reports of key personnel, the use of space, and the consumption of supplies and postage. The expense allocation methods should be reviewed by management and revised when necessary to reflect significant changes in the nature or level of the organization’s current activities.

As you can see, there are many options for functional expense allocation and reporting and there is no single answer on what is appropriate for all organizations. Each organization should review their costs and activities to establish a functional reporting process that is transparent and that is based on a sound reporting methodology. It is critical that expense allocation methodologies represent the activities of your organization, result in fair and reasonable allocations and be applied on a consistent basis.

*This article originally appeared in BDO USA, LLP’s Nonprofit Standard Newsletter – July 2011“. Copyright © 2011 BDO USA, LLP. All rights reserved. http://www.bdo.com

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