Program service or supporting activity? Get your expense allocation right

The push for more transparency from nonprofits has placed a greater emphasis on how an organization’s expenses break down — in other words, how it uses its resources. In 2016, the Financial Accounting Standards Board (FASB) released a new rule that reflects this priority. While the rule has been in effect for almost two years, some nonprofits still struggle with properly allocating their costs.

FASB requirements

In 2016, FASB issued its Accounting Standards Update (ASU) No. 2016-14, Not-for-Profit Entities (Topic 958): Presentation of Financial Statements of Not-for-Profit Entities. The standard, which generally took effect for 2018, requires all nonprofits to include in their financial statements an analysis of expenses by nature (for example, salaries, rent or utilities) and function (program service or supporting activity, including management and general, fundraising, and membership development when significant). Your organization must present information about expenses in one location on its statement of activities, in the financial statement notes or in a separate financial statement.

Organizations that provide voluntary services to solve health or welfare problems have long been required to functionally allocate their expenses. But that doesn’t mean they’ve necessarily been doing so according to FASB standards. Other nonprofits had never performed such allocations. Both types of organizations have run into some common difficulties.

Mishandling of joint costs

Nonprofits often engage in fundraising activities that also have elements of another function. One example: a special event or direct mail campaign that includes both fundraising and program components. Some organizations make the mistake of lumping all joint costs (for example, salaries, consultants, paper and postage) into fundraising.

Under ASU 2016-14, though, you must allocate such costs between fundraising and the other function(s) if certain criteria related to purpose, audience and content are met. If those criteria aren’t satisfied, you should report all costs of the joint activity as fundraising.

Overallocating to management and general function

It’s easy to regard the management and general function as a catchall, especially for expenses that seem like overhead. Some of these expenses, however, properly belong elsewhere. For example, the standard dictates that interest costs (such as mortgage interest on a building) be allocated to specific programs or supporting services whenever possible.

Similarly, certain costs that appear to relate to the management and general function at first glance benefit more than one function. For instance, information technology costs can benefit management and general, fundraising and program delivery. Insurance could cover property that houses multiple functions or a single program. You must allocate these costs accordingly.

Overallocation to management and general conversely results in underallocation to other functions. An employee who normally works as support staff for the executive department might spend some time directly conducting or supervising program services. The executive director may spend a significant chunk of time drumming up donations. You need to allocate their salaries and benefits among those functions, requiring more careful tracking of employees’ time and activities than in the past.

Allocation methods

ASU 2016-14 requires nonprofits to disclose the method they use to allocate expenses among the functions — “guesstimates” won’t cut it. Because it’s both acceptable and advisable to employ different allocation methods for different expenses, you can simplify the disclosure process by developing and adhering to a documented allocation plan.

You might opt to allocate rent, mortgage, utility and building depreciation expense based on total square footage — allocating 40% of the expense to the fundraising department that takes up 40% of the square footage. You can allocate overhead costs to programs based on salary, with a function benefiting from 30% of your total salary expense allocated 30% of overhead. Salaries should be allocated based on actual time and effort expended per function.

Tread carefully

Proper expense allocation isn’t just important for financial reporting compliance; it’s also critical for grant reporting and fundraising. Your CPA can help you develop the processes and procedures to get it right.