Monday, March 29, 2010

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

Monday, March 29, 2010
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.

3 comments:

John

Because of this post, I finally understood how complicated it is to manage funds in an organization, specifically a nonprofit one. Both functional and natural classification of funding must be tracked and accounted for in order to set a good reputation in the public eye. As we all know, nonprofit organizations are established for the betterment of society. A donor or contributor of a specific nonprofit organizations has the right know where the money goes. In that sense, it is an option to use a nonprofit fundraising software or SAGE fundraising software for its accounting, fund raising and payroll/HR needs.

Dan W Boles

is staff included in functional expenses?

Nonprofit Bloggers

Dan, yes, personnel costs are included in functional expense reporting. Hope this answers your question. If you would like to discuss further, feel free to give me a call.

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