Common Functional Expense Mistakes

April 28, 2021

It is important for nonprofits to ensure that the data they present in their functional expense statement or schedule is accurate in order to convey appropriate information to the readers of the financial statements. This means that the data used needs to be properly allocated using reasonable methodologies and attention needs to be paid to the types of expenses and functions that are being presented. Below are a few common mistakes we have identified and how to fix them.

  1. Not Using a Consistent or Reasonable Expense Allocation Method – Costs that are not directly attributable to a specific function need to be allocated among those functions that benefit from it. The way you allocate these costs should be reviewed annually and consistently applied from year to year, unless there is a significant change in operations that causes you to re-examine your methodology. Remember, once you have established an allocation method changing it may represent a change in accounting principle and need to be applied retrospectively unless there is a clear difference in the substance of the transactions or events related to the basis of the allocation. It is helpful to use multiple types of allocation methods depending upon the expenses being allocated, such as using salaries for health care and benefits and using square footage for depreciation and occupancy.
  2. Allocating Management and General Expenses – There are certain expenses that are strictly management and general, just as there are certain expenses that are strictly program. Management and general expenses are those that are the foundation of running the organization. Expenses such as accounting, budgeting, general record keeping, payroll, or any other expense that is related to the oversight and general direction of the organization should be included in management and general. The expenses in management and general should not then be allocated out to program or other supporting service expenses. Only costs related to multiple functions should be indirectly allocated. Examples of these costs are salaries and related benefits, overhead, and information technology.
  3. Lack of Fundraising Expenses – Organizations that solicit donations or volunteers should have fundraising costs. This includes any time spent by any individuals that run fundraising campaigns or maintaining donor databases that might help prepare fundraising materials, distribute these materials, or talk with potential and current donors about giving whether it a monetary gift, non-monetary gift, or volunteering time.
  4. Lack of Membership Development Expenses – Organizations that have members should have membership development expenses. Membership development costs include not only membership relations but also includes soliciting members and other similar. Note that if there is no commensurate value provided to the members in return for their dues that these activities would be considered fundraising and the dues would be contributions.
  5. Too Many Natural Expense Classes – It is best practice to consolidate the natural expense classes so that the reader does not suffer from information overload. For example, rather than presenting legal expenses, accounting expenses, consulting expenses, etc., group these expenses into one natural classification called professional services.
  6. Not Using Natural Expense Classes – Some organizations group expenses in the general ledger for internal tracking and then try to use these same groups as natural expense classes on the functional expense statement. The problem with some of these is that they can be comprised of a number of expenses that are not related. For example, a grouping called industry research could include payroll, consulting, subscriptions, and other expenses. Instead, the underlying expenses should be grouped into natural classes such as payroll, professional services, subscriptions, and others.

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