Stone & Company Non-profit Guidance Series - Statement of Functional Expenses

A statement of functional expenses is simply a statement that presents each expense, as naturally classified (e.g. salaries, rent, office expenses, etc.), but also separated by functional classification, generally three broad categories:
 

• Program – Activities that relate to the non-profit organization’s mission of purpose, these may be a single program or spread across several programs

• Management and general – Activities that are necessary to run the organization but are not directly identifiable with a single program. Such expenses include accounting and overall management of the organization

• Fundraising – Any activity related to inducing donor contributions, or raising funds, including maintaining donor lists, events, and grant writing 

Because some expenses are such that it’s often unclear what portion of the total relates to each program or supporting service, non-profit entities need to think carefully about how they approach preparation of their statement functional expenses.  

In general, all of an organization’s naturally classified expenses will be presented in the statement of functional expenses via one of the following four allocation approaches: 

• Direct Costs – Certain costs relate directly to one or more programs. These may include a consultant hired solely to work in a program. Any such costs can be charged directly to that program. 

• Square Footage – This is a very common approach utilized by the vast majority of non-profit reporting entities for certain expenses because those costs, such as rent, depreciation, utilities and similar costs are highly correlated with the physical spaces occupied by each department. 

• Headcount – This approach may work for certain costs in organizations that are structured such that the functions share virtually no overhead or other costs. Personnel costs are one such category. An example would be an entity where 7 people work in one function and there are 10 employees in total, resulting in 70% of the organization’s total costs being allocated to the program and 30% towards supporting that function.   

• Time Studies – Many organizations will ask their employees to summarize actual time spent over a specified time frame as a basis for future allocations, whether it be related to program, management and general, or fundraising. Allocation of personnel costs can be supported by such a time study, but can also be supported by more detailed records such as actual time sheets and job descriptions.

Regardless of the allocation method used, two important considerations are worth noting: (a) the methodology should be reasonable, based on the type of expense and (b) the methodology must be documented. A written cost allocation plan has a number of benefits. It not only helps an organization apply a consistent methodology on an ongoing basis, it also facilitates a more efficient audit and, for those non-profit entities that receive government funds or are parties to contracts that require such documentation, it is required record keeping. The need to document the cost allocation methodology and basis for utilizing that methodology cannot be overemphasized, especially for those entities that are subject to a financial statement audit or inspection by an outside entity.    

Draw from the reporting that is already required in your Form 990. Functional reporting is already required in this annual non-profit tax return and there may be some benefit in using that as a model when preparing GAAP financial statements, grouping and summarizing line items as appropriate. 

Don’t forget to review methodologies and the allocation approach for each expense category. Things change. More space may be rented, departments may be reorganized, staffing levels and mix may change. A review should be done annually to ensure that costs are being allocated in a manner that truly reflects how resources are being consumed by each program or supporting service. 

Don’t forget about any expenses that are netted against a revenue source on the statement of activities. Such expenses may cause a reconciling item and can be shown as such on the statement of functional expenses to ensure the subtotal number ties back to the statement of activities.   

Remember to allocate interest expenses to the programs that benefit. Some organizations erroneously report all interest expense in the general and administrative category. However, since debt is usually issued for the construction or purchase of a building, a reasonable allocation method could be based on square feet occupied, including space occupied by programs. Interest costs that cannot be allocated should be reported under management and general expenses.

Insurance expense is not always a general and administrative expense. Certain types of insurance, such as property and casualty insurance covering the space occupied, includes coverage for space occupied by programs. As such, a portion of those insurance costs should be allocated to the programs that benefit.  

If contributions are significant, it is likely that there should be some fundraising expenses presented. Even if there is no dedicated fundraising person or department, it’s likely that at least one person dedicated some portion of their time developing and securing those contributions. Generally, there was some activity that resulted in those contributions to the organization.

Non-profit entities that prepare GAAP financial statements should talk to their CPA. This is especially important for those entities that undergo an annual financial statement audit. Your auditor will typically have worked with a variety of non-profits that prepare statements of functional expenses, be familiar with best practices, and will almost always be a great resource. 

We have found that our non-profit clients who stay engaged with us tend to experience greater efficiencies when preparing their statement of functional expenses and their financial statements as a whole. 

 

The statement of functional expenses is now a required part of your financial statements prepared in accordance with GAAP. Familiarity with best practices and generally acceptable approaches can go a long way towards saving valuable time and making the best use of resources.   

Robert S. Miller, CPA, CFE, is the managing partner and leads the assurance services practice at Stone & Company, Lexington, MA. rmiller@stonecpas.com 

For additional information about non-profit reporting and other information about how our team can help, please contact us at https://www.stonecpas.com/contact