Not-for-Profit Reporting Model - Part 4: Functional Expense Allocation Review

Given the time of year, many tax-exempt organizations are currently going through their year-end close and may be preparing for an upcoming financial statement audit. Tax-exempt organizations, unlike for-profit entities, are required to report their expenses according to the purpose for which they are incurred, which is referred to as a functional allocation of expenses.

Expenses for tax-exempt organizations are required to be grouped into two broad functional categories; either program or supporting service expenses. Both of these categories can be further broken down. Program expenses can be broken down to separately report all of the various operating programs, and supporting service expenses can be broken down to include management and administrative expense as well as development or fundraising expenses. Expenses are either directly applied to the appropriate functional category or indirectly applied through an allocation process.

It is essential that an organization’s management have an in-depth understanding of the functional expense categories when developing the organization’s functional allocation policy.

Fuctional Expense Categories for Tax Exempt Organizations

• Program Service Expenses – These are the costs associated with the activities that result in goods and services being provided to beneficiaries, customers or members that fulfill the purposes or mission for which the organization exists.
• Supporting Service Expenses – These are costs related to administering the day-to-day activities of the tax-exempt organization. These expenses do not directly relate to the purpose for which the organization exists and typically includes activities such as bookkeeping, governance or the appeal for financial support (fundraising).

It is very important for tax-exempt organizations to establish a written functional expense allocation policy. This policy should be reviewed and updated at least annually.

Best Practices for Establishing a Functional Expense Allocation Policy

• Obtain the organization’s chart of accounts, which can be used to facilitate the allocation process in an efficient manner.
• Identify the types of expenses that will need to be allocated to various functional categories.
• Maintain timesheets for individuals whose efforts are spent on more than one functional or programmatic activity. These timesheets should include the amount of time that particular person spends on each activity.
• Consider allocating rent and other office space-related costs based on the square footage occupied by the various program or functional activity.
• Remain consistent with the functional expense allocation policy and try to refrain from making exceptions to the policy.

Allocating functional expenses and coming up with a functional expense allocation policy can be challenging. Typically, if an organization has developed a reasonable allocation policy, and consistently follows it, it is better able to analyze operating results.

In April 2015, the Financial Accounting Standards Board issued a Proposed Accounting Standards Update (ASU) relating to the presentation of financial statements for not-for-profit entities. This ASU, when finalized, may have an impact on functional expense reporting. We will issue future updates on this proposed ASU and the impact on functional expense reporting as it continues to evolve.

Contact us if you have questions regarding your organization's functional expense allocation policy and visit the Our Thoughts On blog for more articles pertaining to the not-for-profit industry.