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Statement of Functional Expenses: Three Steps for Accurate Expense Allocations

An area of common concern for not-for-profit organizations is how to best allocate certain expenses among the various functions between management and general activities, program services and other supporting activities like fundraising and membership development. Users of your financial statements, and of course your auditors, will want to ensure that expenses that are not directly attributable to a specific function are allocated in a rational and consistent manner.

The next time you make expense allocations between functions, keep the following few steps in mind:

Step 1: What to Allocate

Indirect costs that directly benefit more than one function should be allocated. The key to remember is that not all indirect costs should be allocated, but only those that directly benefit one or more function. These costs commonly include occupancy-related expenses such as depreciation, rent, and utilities.

Administrative salaries are another example of indirect costs that may directly benefit multiple functions. The Financial Accounting Standards Board (FASB) has clarified that activities performed by administrative staff that represent direct conduct or direct supervision of program or other supporting activities require an allocation from management and general activities. For example, if you can reasonably estimate and support the amount of time and effort that the Chief Executive Officer directly conducts and directly supervises program services and other supporting activities, then an allocation of their wages would be appropriate.

Step 2: What Not to Allocate

Indirect costs that indirectly benefit each function should not be allocated. These costs primarily benefit the organization as a whole and should be presented under management and general activities. There has been diversity in practice on how to treat costs for accounting services, human resources, and payroll, for example. The FASB has made it clear that these costs benefit the organization as a whole and should remain entirely under management and general activities.

Step 3: How to Allocate

A rational methodology must be selected and disclosed in the notes to the financial statements. The allocation methodology you select should be based on a cause-and-effect relationship between the allocable indirect costs and your allocation methodology.

For example, the effect of utilities expense is caused by the amount of square footage each function occupies, so allocating utilities expense to each function based on this cause-and-effect relationship is appropriate. Similarly, the effect of officers’ compensation and benefits is caused by time and effort. In this case, you could allocate officers’ compensation and benefits based on hours spent on direct conduct or direct supervision of program services or other supporting activities derived from your time entry software.

Hopefully, these steps help you feel more confident about making allocations on your statement or disclosure of functional expenses, but if you have any questions, please contact your local Blue & Co. advisor for assistance.

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