A well-designed expense allocation system is an absolute necessity for high-performing not-for-profits (NFPs). Yet, for many working in the not-for-profit sector, it presents a challenge for organizations and their auditors. From a financial manager’s standpoint, selecting and implementing a cost allocation approach requires careful planning and consideration. An NFP’s auditors assess risks of misstatement and design audit procedures to respond to assessed risks, independently reviewing and testing management’s significant underlying assumptions.
For both financial managers and their auditors, it is important to understand what information is useful to financial statement readers – and why. An NFP’s mission-centric programs are the heart of the organization. All activities and infrastructure supports the achievement of the mission. Under current reporting standards, activities are identified as either program services or supporting services, and indirect costs are allocated to these functions. This information is reported in financial statements prepared in accordance with GAAP, as well as in the IRS Form 990 of most tax-exempt NFPs.
Functional expense reporting is intended to reflect the costs of the major activities of the organization. If expenses are not allocated thoughtfully, this could result in an inaccurate picture about the costs of the activities undertaken to achieve the organization’s mission.
For internal reporting purposes, information produced from a system is only as good as information that goes into it, and organizational leaders rely on this information for decision-making and strategic planning. From an external reporting perspective, an NFP’s constituents want to know, and have a right to know, how the organization spends resources to accomplish its mission.
When considering the cost allocation approach, think about the needs of the internal and external users of the financial statements. These include:
- Organizational leaders and those charged with governance of the organization use this information to exercise oversight of the entity’s resources, make decisions about future resource allocation, and develop strategies to advance the organization’s mission. This information may be included in dashboard reporting and benchmarking analysis.
- Donors use financial information to help understand how well an NFP is doing in fulfilling its mission and its stewardship of resources.
- Creditors use the financial statements to understand an NFP’s current financial position and its longer-term sustainability.
- Sponsors are those entities that provide funding for a particular program in the form of exchange transactions – frequently in the form of government grants or contracts and have a need for understanding allocation of resources.
- Rating agencies use the financial statements as a basis for much of their analysis reported to members of the public, who are looking to become informed about a particular organization. They benchmark the percentage of expenses devoted to programs as a key component in the formulas they use to monitor, rate, and compare NFPs.
- The press may refer to information as context for information presented in news articles, or for use in holiday charitable ‘giving guides’ and such.
Additionally, as the organization evolves and grows, it is a good practice to review periodically the allocation approach to consider the significance of new strategies, programs or organizational structures as it relates to overall activities. An understanding of the requirements and considerations related to cost allocations and functional expense reporting is an excellent starting point.
The AICPA’s Not-for-Profit Section has published background papers that summarize the reporting standards and provide practical tips for financial managers of NFPs and their auditors. Click on the links below to access these new resources.
Functional Expense Allocation: Getting It Right (PDF)
Get a detailed overview of the reporting requirements and tips for designing and optimizing an NFP's expense allocation system.
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