How to Allocate Functional Expenses for Nonprofits

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Nonprofit reporting is different from that of a for-profit business, with nonprofits issuing the following financial statements.

  • Statement of financial position: This is similar to a balance sheet, reporting on assets, liabilities, and net assets, which is similar to owner’s equity.
  • Statement of activities: The statement of activities is similar to a standard income statement, which looks at revenues and expenses for the organization.
  • Statement of cash flows: Like a standard cash flow statement, the statement of cash flows for a nonprofit displays the same information based on organization activities.

The final report that nonprofit organizations are required to run is the statement of functional expenses, which reports expenses based on functional classifications. Every nonprofit has functional areas that they need to report on, but because the money to fund nonprofits frequently comes from grants, campaigns, and fundraising activities, nonprofits must track organizational expenses differently than a standard business.


Overview: What are functional expenses?

Before you can use any of the allocation methods outlined below, you need to understand functional classifications. In nonprofit accounting, all expenses need to be recorded in one of these three nonprofit expense categories.

Programs: All nonprofit organizations have a mission. A program is an activity that is created to fulfill that mission. Depending on the organization, you may have a single program, such as feeding the hungry, or you may offer several programs, such as prenatal support for expectant teen mothers as well as GED classes to further their education. Expenses for each program need to be recorded separately.

Management and general expenses: Management and general expenses are items that are not attached to one particular program but are a required part of the operation of the organization. For instance, the salary of the executive director and other officers would be considered management and general expenses, as would the staff accountant who manages the books for all programs.

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Fundraising expenses: While it may seem strange to place fundraising in an expense category, nonprofit organizations spend a lot of money on fundraising. This includes salary expenses for development and fundraising employees and the expense of creating and mailing annual appeal letters, including the cost of printing, paper, and postage.

In many cases, functional expenses are easily categorized, but if not, you’ll need to allocate them accordingly.


The 4 allocation methods for functional expenses

While you can allocate expenses as needed, the following allocation methods are the ones most frequently used by nonprofit organizations. The easiest way to allocate your expenses is by using nonprofit or fund accounting software, although regular accounting software can also be used if necessary.

1. Direct cost

The easiest costs to allocate are those that can only be allocated to a single category. For example, a grant that Sam receives allows him to purchase a variety of canned and non-perishable foods for his community food pantry. This cost can be directly allocated to programs since the grant and resulting expense both directly relate to the cost of the community food pantry program.

2. Employee time

If employees split their time between several programs or organizational areas, their time must be tracked and allocated properly. For example, Ann runs an agricultural nonprofit called Back to the Land that offers several different programs ranging from onsite farm training to financial planning seminars for farm and ranch owners.

Because her staff is very small, employees not only spend program hours training farmers, but they also do administrative work, with Ann herself often splitting her time between training farmers and running the organization.

Currently, Ann spends 25% of her time training, dividing her time equally between both programs. She also spends 25% writing grants and 50% running the organization. Based on these percentages, let’s allocate Ann’s salary, which is $4,000 per month.

Statement of Functional Expenses
Back to the Land
July 2020

Expenses

Program A

Program B

G&A

Fundraising

Total

Salaries

$500

$500

$1,000

$2,000

$4,000

The partial statement above displays the three functional expense categories: Programs, General and Administrative (G&A), and Fundraising, with the line item displaying exactly how Ann’s $4,000 salary for July was allocated.

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3. Employee headcount

For very small nonprofits, it might be easier to base costs on total employee headcount. This method uses the total salaries of each employee, combining them into one total and then allocating the total based on the amount of time spent in each functional expense area.

While this method doesn’t work for organizations with numerous employees who have well-defined areas of responsibility, for the nonprofit whose employees work in all functional expense areas, the total salary can be allocated between those areas.

For example, Jason runs Coats 4 Kidz, a nonprofit that collects and distributes winter coats to kids from low-income families. He only has a staff of two, and all three of them routinely work wherever they’re needed. Together, the three employees spend 60% of their time in programs, followed by 25% in G&A and 15% in fundraising. With a total salary expense of $6,000 between the three, let’s allocate their salary expenses.

Statement of Functional Expenses
Coats 4 Kidz
October 2020

Expenses

Programs

G&A

Fundraising

Total

Salaries

$3,600

$1,500

$900

$6,000

4. Square feet

The square feet allocation method is probably the most detailed. The square feet method can be used to properly allocate the following expenses:

  • Utilities
  • Rent
  • Building depreciation
  • Insurance

If your nonprofit is housed in one large space without offices, this method won’t work, but for those that have defined areas in the office, such as a reception area or break room or separate offices for staff, you can allocate the above expenses based on square footage.

Going back to Coats 4 Kidz, let’s say the nonprofit is currently housed in a 1,000-square-foot office space. Twenty-five percent of the space is used equally by all employees, while 30% is occupied by program staff, fundraising occupies 25%, and management takes up 20%.

In October, Coats 4 Kidz had the following expenses:

  • Utilities: $350
  • Rent: $1,500
  • Building depreciation: $400
  • Insurance: $375

Let’s start with the common space, which takes up 25% of the 1,000 square foot office. To calculate the cost of utilities for October, we would need to do two calculations:

$350 x 25% = $87.50

That is the total allocation for the open space in the office. Next, we need to divide that amount by all three functional expense categories. This can be done by the area used by each category or by the number of people in each department, whichever is easier.

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$87.50 ÷ 3 = $29.16

That means that we’ll have to allocate an additional $29.16 in utility expenses to each of the three functional expense categories.

Statement of Functional Expenses
Coats 4 Kidz
October 2020

Expenses

Programs

G&A

Fundraising

Total

Utilities

$134.16

$99.17

$116.67

$350

Rent

$575

$500

$425

$1,500

Building Depreciation

$153.33

$133.33

$113.34

$400

Insurance

$143.75

$125

$106.25

$375

So, if we calculate the utility expense for programs for October, we would do the following calculation:

$350 x 30% = $105

We would then add the additional $29.16 to that total to have the complete allocation for the month.

$105 + $29.16 = $134.16

You would just follow the same process to allocate the rest of the expenses.


An example of a statement of functional expenses

If we take the salary portion of the statement of functional expenses above and combine it with the other expenses, you’ll have a complete accounting of expenses for October.

Statement of Functional Expenses
Coats 4 Kidz
October 2020

Expenses

Programs

G&A

Fundraising

Total

Salaries

$3,600.00

$1,500.00

$   900.00

$6,000.00

Total Salaries

$3,600.00

$1,500.00

$   900.00

$6,000.00

Utilities

$   134.16

$     99.17

$   116.67

$   350.00

Rent

$   575.00

$   500.00

$   425.00

$1,500.00

Building Depreciation

$   153.33

$   133.33

$   113.34

$   400.00

Insurance

$   143.75

$   125.00

$   106.25

$   375.00

Total Expenses

$4,606.24

$2,357.50

$1,661.26

$8,625.00

You would only need to add revenue totals for the month to have a complete statement of functional expenses.


The statement of functional expenses is a must for any nonprofit

According to Generally Accepted Accounting Principles, or GAAP guidelines, nonprofits are required to properly categorize functional expenses. After all, granters want to know how you spent their grant funds, while the general public wants reassurance that their donation is being used responsibly.

Understanding the statement of functional expenses may take a bit of time, but it is an important part of managing your nonprofit properly. Fund accounting software can make managing and allocating expenses an easier process, while consulting with a CPA who specializes in nonprofit accounting can also help.

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