By Luke Pierce, CPA, Manager at Blue & Co.
What Are Functional Expenses?
Under financial reporting standards, all not-for-profit entities are required to present a statement of functional expenses, either within the actual financial statements or as a disclosure within the notes to the financial statements. While natural expenses show the type of expense incurred, functional expenses represent the purpose of the expenditure.
There are three general categories of functional expenses:
- Program services – the costs incurred in relation to the primary purpose of the organization.
- Fundraising – the expenditures allocable to the costs of soliciting and securing contribution and grant revenues.
- Management and general – expenses that are not directly related to either of the aforementioned categories but are necessary to maintain company operations.
Each of the general functional expense categories can be further broken down to specific subgroups that more clearly classify the nature of the organization’s expenses.
For example, a fraternal organization may choose to break out its program service activities between categories such as chapter services, conferences and conventions, housing programs, etc. Doing so provides greater insight to prospective donors and other readers of the financial statements as to how the organization is using its resources.
How Are Functional Expenses Allocated?
Functional expenses are simply an allocation of expenses based upon the purpose of the underlying expenditure. While the definition is straightforward, actual allocation methods are vague and can vary greatly across different organizations.
Costs that can be readily identified as pertaining to a specific category are charged directly to that function. For example, if an organization formed for the purpose of providing financial assistance to students disburses a scholarship, that full amount would be recorded under program services. Many expenses incurred by organizations, however, are not so straightforward.
Expenses such as payroll costs, depreciation, and rent are typically attributable to multiple functional expense categories. Common benchmarks for calculating allocation across different categories are estimates of staff’s time and effort for payroll costs and square footage for occupancy costs.
Expenses that require allocation among multiple categories require a large amount of management estimation as most organizations do not require their staff to track time spent for specific purposes and have not sectioned off their building for its various operations.
Why Does Functional Expense Allocation Matter?
All not-for-profits are required to report their functional expenses; however, the breakout of functional expenses is particularly important to organizations whose revenue is primarily comprised of contributions from donors.
All not-for-profits are required to file a Form 990, which is an informational return that is made publicly available. Form 990s include a breakout of allocation between functional expense categories. Many donors will review organizations’ Form 990s as part of deciding which organization they wish to donate.
As program services represent expenses directly related to an organization’s primary purpose, a charity that reports a 75 percent allocation of total expenses to program services will appear favorable in the eyes of a donor compared to an organization that reports 55 percent of total expenses being program services as the latter implies 45 percent of donations won’t go toward the purpose of the organization.
Given that many expenses are prone to management estimation as to allocation between categories, this creates a management incentive to overstate program service expenses by using aggressive estimates on expenses split between multiple categories.
What Can an Organization Do To Assess Whether or Not Its Functional Expenses Are Accurately Reported?
As functional expenses are largely calculated based on management estimation and as the underlying rationale for those estimates are often unobservable and intangible, assessing whether or not functional expenses are accurately reported is inherently difficult. There is not an established standard for functional expense allocations.
A general benchmark is a 65/25/10 percent split between program services, management and general, and fundraising, respectively; however, allocations can vary greatly across different industries and these percentages should not be used as a universal guideline.
Organizations should have an understanding of their methodology for allocating expenses and a process in place for the underlying calculations for those allocations. If a specific methodology is not in place and underlying calculations to support allocations are not maintained, implementation of these processes should be considered.
Another way to assess whether or not functional expenses are being accurately reported is to compare the functional expense allocations to other organizations within the same industry. This information can be easily accessed via a lookup of similar organizations’ Form 990s on GuideStar or other similar sites. If the allocations are far out of line from the organization’s peers, it could be an indication that the method for allocating functional expenses should be revisited.
Lastly, a year-to-year comparison of functional expense allocations should be performed. Any significant fluctuations between years should be further investigated.
Overly aggressive allocation toward program services may result in skepticism and distrust from a knowledgeable donor, while understatement of program services may lead donors to direct their contributions to other organizations. Ultimately, it is both the not-for-profit’s requirement and benefit to accurately report its functional expenses.
For additional guidance on accurately reporting your functional expenses, reach out to your local Blue & Co. advisor today.