Monday, March 29, 2010

Functional expense reporting - What does this mean and why is it necessary?

Monday, March 29, 2010 3
Non-profit organizations that present their financial statements in accordance with generally accepted accounting principles ("GAAP") are required to report their expenses by their "functional" classification either in the Statement of Activities or in the Notes to the Financial Statements.

Tax exempt organizations who file the Federal Form 990 must report their expenses in the Statement of Functional Expense, and document the method of allocation in their records.
The Financial Accounting Standards Board defines functional classification as "a method of grouping expenses according to the purpose for which costs are incurred. The primary functional classifications are program services and supporting activities". (SFAS No. 117, par. 168)

Program services are activities that provide goods and services to the beneficiaries, customers and members of the non-profit organization that fulfill the purpose or mission for which the non-profit organization exists. (SFAS No. 117, par. 27)

Supporting services are activities not directly related to the purpose or mission for which the non-profit organization exits, but which are necessary for the non-profit organization to operate. Supporting services generally include management and general, fund raising and membership-development activities. (SFAS No. 117, par. 28)

Most financial statement users are more interested in the functional classification of expenses than in the natural classification (e.g. payroll, rent, supplies, travel, etc.). Functional classifications help management see exactly where funding is going, so they can better run the organization. Board members look at functional classification to assess how well the organization is performing. Funders and the general public want to know how much of each dollar they contribute is spent on achieving the organization's purpose or mission.
While GAAP and the Federal Form 990 are very specific in saying that you must report costs by functional classification, they are somewhat vague about how a non-profit organization should do this. Direct costs that are associated with a specific program or supporting service should be charged directly to that functional category. That's the easy part! But what if I have a cost that pertains to more than one functional expense category, i.e. indirect costs? Both GAAP and the Form 990 require these costs to be allocated using a method that is both reasonable and consistent from year to year.

Considerable freedom is allowed in applying judgment when determining reasonable allocation methods. Here are some guidelines to follow:

  • Objective allocation methods are preferred over subjective methods. For example, it's better to allocate salaries based on time sheets or a time study rather than on a subjective estimate of how time was spent.

  • Different allocation methods may be used for different types of expenses. For example rent and utilities might be allocated based on square footage. You need to review each expense account and determine an appropriate allocation method to use for each.

  • Consistency from year to year is strongly recommended, but facts and circumstances may change from year to year, necessitating a change in allocation method.

  • Review your allocation methods each year to be sure they are still appropriate under the current circumstances.
For more information or guidance on reporting functional expenses or the cost allocation process, please contact Elko & Associates Ltd. We can help you understand the accounting rules described above and the appropriate methodologies to apply to your internal accounting records (including chart of accounts), so that management, the Board, funders and the general public have the right information to make sound business and giving decisions.

Tuesday, March 16, 2010

The Misunderstood "Foundation"

Tuesday, March 16, 2010 0
Although I have developed a special affinity for and interest in tax-exempt organizations, my real bread and butter, so to speak, is as a tax professional. And as I look at the calendar, today is March 15. This means we are right in the belly of the tax season beast. I also lost an hour of sleep over the weekend which I am not too happy about.

Corporate returns need to be filed or extended today! Then we get into the stretch run, the march towards April 15. “Into the valley of death……”. No food or water for days. Your family forgets who you are, sometimes intentionally. You get home at night only to find that your 70-pound greyhound (“Roxy”) has taken over your side of the bed, and isn’t moving for anybody. Off to the couch and Seinfeld reruns.

Now you might be asking, what has any of this to do with foundations? I will respond- absolutely nothing! That’s why blogging is so much fun. However, the real point of my tirade is that I haven’t really had the time to focus on a specific topic to blog about. And, with all kidding aside, these blogs are important to me and my non-profit colleagues, as well as our firm. Thus, here’s a little conversation about foundations.

The reason I use the word misunderstood is based on my experiences over the years with individuals who are thinking about, or who are in the process of, forming a charitable organization. About 50% will say that they are forming a charitable foundation, at which time I will put on my “Mr. Smarty Pants” hat and say, “Are you talking about forming a private foundation?” And, even though they may be on the telephone, I can see their face transforming into a large question mark.

Inevitably, they are simply talking about forming a “publicly” supported public charity, not a “privately” supported private foundation. To their defense, we do see many publicly supported charities use the term foundation within the name of the organization. There are also many private foundations that do not have the word foundation as part of their name.

So, when someone is talking to you about a foundation, be sure you know exactly what they are talking about. This is important from an advisory standpoint since each type of charitable organization, whether it be publicly supported or a private foundation, has specific issues, guidelines, etc. that must be addressed and adhered to. For example, after 5 years in existence, a publicly supported charity will need to make sure that it does not fail the public support test for 2 years in a row. A private foundation does not have this concern. However, a private foundation does have to calculate a required distribution each year. This required distribution amount is a percentage of the foundation’s average non-charitable use assets, and the foundation has until the end of the following year to make the distribution.

Private foundations pay tax on their net investment income. Publicly supported charities as a rule do not, unless the income is determined to be unrelated business income. One area where both types of these charitable organizations have to “toe the line” is in regard to situations where a private individual may personally benefit from the organization’s assets or income. Public charities have the private inurement, private benefit and intermediate sanction rules to deal with when these types of transactions arise. Private foundations have the self-dealing rules which are in place to prevent these types of activities.

Well, I could go on and on about private foundations, but it is time to get back to the tax returns and the long march to April 15. Let’s raise a glass to large tax refunds, pleasant client relationships, and getting home before Roxy gets into the bed!

Monday, March 8, 2010

Does My Non-profit Need an Audit?

Monday, March 8, 2010 0
I get a lot of phone calls from prospective clients inquiring if we do audits, and the cost to do an audit. After I advise them that we do provide audit and other attest services, I ask them a simple question – Why do you need an audit? Often times there's silence on the other end of the phone or the answer is “I’m not sure” or “My boss asked me to call” or “I’m a non-profit, aren’t I supposed to have an audit?”

While the question is simple the answer might not always be as simple. The fact is, there may be several reasons a non-profit organization should have an audit, and reasons you may not need an audit. The following are reasons your non-profit may need or require an audit:

Grantors/Donors – As more non-profit organizations increase their fundraising efforts they often seek grants from various foundations and public/private sector agencies. These agencies may require that audited financial statements be provided or accompany the grant application. These agencies want to make sure that their money is going to legitimate, financially stable organizations that have reasonable controls in place to ensure the money will be spent for the purpose requested. These grantors may also request a copy of a management/deficiency letter that may be the by-product of the audit and addresses control or operational deficiencies and related recommendations to address these deficiencies. These grantors may require audited financial statements throughout the grant period as well for the same reasons, to monitor the use of the proceeds and the financial health of the non-profit grantee.

Federal, state and local government agencies – Some non-profit organizations receive grants or other awards from government agencies, and the related agreement may require that the recipient organization have an organization-wide audit that includes some level of testing of compliance and internal controls. The infamous “Single Audit” or audit in accordance with OMB Circular A-133 may be a requirement of the grant agreement, and is generally required for organizations that have total expenditures of federal awards in excess of $500,000 during the organization’s fiscal year. These federal awards may be direct awards from the federal government or pass-through awards to state or local government agencies that are ultimately passed through to the non-profit organization.

State law - Pennsylvania, for instance, requires organizations soliciting funds for a charitable purpose to register with the Department of State's Bureau of Charitable Organizations, file an annual registration statement, a copy of its IRS Form 990, and the appropriate financial statements. Organizations receiving $300,000 and over must file audited financial statements with the annual registration form.

Banks, vendors, landlords or other independent third parties - Loan agreements may have covenants or other provisions requiring the borrower to submit annual audited financial statements so they can get an accurate picture of the organization's financial status. Vendors, landlords, and other third parties may have the same requirements depending on the level of financial interaction and resources at stake.

Internal control - Management and/or those charged with governance (i.e. the Board of Directors) may believe that having an annual audit is a good internal control over financial reporting and safeguards assets of the organization. In general, an audit should not be relied upon as a primary internal control. This can be expensive, and while testing may be done for transactions that occurred throughout the year, the annual audit is performed once a year at the end of the organization's fiscal year. Management should ensure that good internal controls are in place throughout the year to safeguard the organization’s assets and promote good financial reporting.

In summary, while an audit may be perceived as a good annual check-up for the organization, management needs to consider the cost vs. benefit before making such an investment. In some cases, as noted above, the decision may be out of your control and a third party may be the one making the decision for you.

Still not sure? Contact us

Monday, March 1, 2010

Governance Practices Assessment

Monday, March 1, 2010 1
Public charities BEWARE! IRS audits are becoming more intrusive. Although the IRS doesn’t mandate the governance practices it’s inquiring about on Part VI of the Federal Form 990, it is focusing on the answers to those questions. The IRS recently created the Governance Check Sheet (Form 14114) that its examining agents will use to capture data about the governance practices and related internal controls of your public charity. The IRS claims they are gathering this data in an attempt to gain a better understanding of the relationship between governance practices and tax compliance. Hmmm . . . The IRS believes that prudent governance practices lead to better tax compliance. Perhaps this explains the motive behind the numerous governance questions in Part VI of the Federal Form 990?

The Governance Check Sheet will explore the following areas:
• Governing Body and Management – includes questions about the public charity’s
  • Mission statement
  • By-laws and articles, and
  • Board members and board meetings
• Compensation – includes questions about
  • Compensation arrangements for trustees, directors, officers, and key employees,
  • Compensation determinations, and
  • Comparability data considered
• Organizational Control – includes questions about the public charity’s
  • Family and business relationships, and
  • “Effective control” of the organization
• Conflict of Interest – includes questions about the public charity’s
  • Conflict of interest policy
• Financial Oversight – includes questions about the public charity’s
  • Use of its assets
  • Financial reports provided to/discussed with board members
  • Board’s review of the Federal Form 990 before filing
  • Independent accountant’s report
  •  Management letter
• Document Retention – includes questions about the public charity’s
  • Document retention and destruction policy
  • Minutes of board meetings
So what can public charities do to prepare themselves? They can perform a governance practices self-assessment! This assessment should be performed even if the public charity currently files the Federal Form 990-EZ. Beginning in 2010, an organization exempt from income tax under IRC Sec. 501(a), which includes organizations described in Sec. 501(c)(3), must file Federal Form 990 if it has either gross receipts of $200,000 or total assets of $500,000 at the end of the tax year. The Governance Check Sheet is available here.

Are you a new organization that is applying for recognition as a tax-exempt organization? Then you should consider the questions in this Governance Check Sheet when you complete the application for recognition of exemption. And, whether you’re an existing tax-exempt or an organization applying for tax-exempt status, be sure to maintain documentation to support your answers. Revenue agents are being asked whether their examinations were “hindered by a lack of necessary documentation” (question #26 of the check sheet).
Feel free to contact us if you have any questions or need assistance with any of these matters. But don’t wait – it’s better to have the answers before the IRS asks the questions!!

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