Failing to categorize or allocate expenses properly is a common accounting mistake some nonprofits make.
A nonprofit organization’s expenses can be broadly categorized as expenses for program services and for supporting services. Expenses can also be classified by a natural or a functional classification.
Natural and functional classification of expenses
Expenses classified by their natural classification provide information about the type of expense incurred, such as salaries, rent, supplies, etc. Conversely, expenses classified by their function provide information about the purpose of the expenses.
The primary functional classifications are program services and supporting services. Basically, a functional expense tells us why money was spent instead of what it was spent on.
Program service expenses
Program service expenses include costs of activities related to the purpose of the organization. For example, a nonprofit whose purpose is to feed the homeless would include food and food preparation costs under program service expenses.
Supporting services expenses
Supporting services expenses are costs for activities not directly related to the purpose of the organization. Using the previous example of the nonprofit whose purpose is to feed the homeless, supporting expenses may include costs for the governing board or accounting fees.
Supporting service expenses are broadly categorized as:
Management and general – relates to the overall direction of the nonprofit organization
Fundraising – relates to costs associated with requests for monetary funding
Membership development – relates to membership dues, solicitation of new members and similar expenses
Cost allocation between functions
While some costs can be identified to a specific program, others cannot. Expenses that relate to more than one function should be allocated between the pertinent functions.
When allocating expenses between functions, the organization should apply a reasonable method. It’s important that the basis for allocating expenses between functions be consistent from period to period to ensure comparability, but changes can be made to the basis for allocation if needed.
The use of estimates is permitted when allocating expenses. The method used to allocate expenses may vary depending on the actual expense being allocated. For example, occupancy expenses – such as rent and depreciation – can be allocated based on the square footage of space occupied by each program and supporting service.
Another example would be employees who spend half their time on strictly administrative functions and the other half on the purpose of the organization. Those employees’ salaries and benefits should be split evenly between program services and management and general functions.
Functional expense reporting
Accounting literature requires all nonprofit organizations to provide information about expenses reported by their functional classification. The information may be presented either in the notes to the financial statements or on the statement of activities.
Accounting literature also requires all voluntary health and welfare organizations to include a Statement of Functional Expenses in their financial statements. While the Statement of Functional Expenses is not required for other nonprofit organizations, it is recommended. Functional expenses are also reported on an organization’s IRS Form 990.
Common accounting mistakes to avoid
All money coming in and out of your organization must be assigned to the appropriate category. Proper assignment is particularly important if you accept donations that may be earmarked for certain projects or programs.
The following are common allocation errors that organizations make:
- Classifying all expenses as program expenses
- Failing to allocate personnel or occupancy expenses between the appropriate functions
- Reporting significant contribution revenue but little or no fundraising expenses
- Outside reliance on functional expense reporting
Many nonprofits rely on outside contributions and grants. In deciding which nonprofit to donate their money to, some benefactors place reliance on financial indicators, many of which are based on reported functional expenses.
Two commonly used financial indicators are:
Program-spending ratio – total program expenses divided by total expenses
Fundraising-efficiency ratio – fundraising costs divided by total contributions
Providing inaccurate financial information to grantors and donors may hinder an organization’s possibilities of receiving the financial support requested.