Why is functional expense reporting so important for nonprofit organizations?

One good reason is that the IRS is looking at it as a part of their review of your organization’s Form 990. Some of things they may be more specifically looking to see is if the allocation of expenses are reasonable, that the expenses are consistent with the organization’s exempt purpose, and that the expenses are consistent with similar organizations. The IRS ultimately is looking to see if the organization should retain its tax exempt status.

Another good reason is that your donors are more than likely evaluating the expenses your organization makes. More specifically, they may be looking for minimal administrative expenses, examining the amount spent on soliciting contributions, and ensuring that the majority of funds are used to further the organization’s program or purpose. Ultimately your donors want to know that their contributions are being used to provide those programs and services.

With all of this in mind, what are some of the most common errors made when allocating functional expenses reported on the Form 990?

• Reporting all expenses as program expenses
• Waiting until the end of the year to allocate costs in preparation for the annual audit
• Using a fixed percentage to allocate costs rather than a systematic or rational basis
• No allocation of personnel or occupancy expenses between categories
• Reporting substantial contribution revenue and no fundraising expenses
• Not allocating insurance, occupancy, and depreciation
• Charging all accounting fees to programs

Here are some suggestions on how to remedy some of the issues you may have experienced above.

• If an expense can be specifically identified with a program, support service or fundraising, it should be assigned to that function. Use a specific code within your financial software to indicate what function the expense should be assigned to when recording the transaction.
• Perform a time study for those payroll related costs in which an employee is splitting time between different functions and allocate the cost amongst the functions accordingly.
• Analyze square footage usage for occupancy/rent costs between the functions and split those costs based on the analysis.
• Use the number of employees the organization has and allocate expenses by each employee’s function of the organization.
• Accounting fees should be recorded as a support service expense only
• DOCUMENT, DOCUMENT, DOCUMENT! Maintain documentation that supports the reasonableness of the method in which the organization chooses to allocate expenses and stay consistent from year to year. Review the methods used and ensure that the method is still reasonable, especially when more significant changes occur to the organization.
• Lastly, you can contact our firm and we would be happy to provide additional guidance specific to your organization.