Understanding Functional Expenses – Part 1 of 4
In our last post, Demystifying Nonprofit Overhead, we began to tackle the concept of “overhead” and why it’s sooooo important for you to understand it. Overhead refers to expenses that are NOT program expenses. You may find it helpful to read that post if you haven’t already.
To quickly review, Form 990, the annual information return required of many nonprofits, as well as audited financial statements require expenses to be presented by three functional areas:
1. Program services
2. Management and general
Management and general expenses and fundraising expenses are referred to collectively as supporting services. Once you understand that expenses for program services are considered separately from all the other expenses (supporting services) involved in operating a nonprofit organization, you are on your way to understanding functional expense reporting.
In the last post we left you with some questions — How are nonprofits supposed to keep track of program expenses vs. nonprogram expenses? And what is a cost vs. an expense?
In this post we’ll address that last question. We’ll also cover fundraising expenses in greater detail. In our next post we’ll cover the details of management and general expenses. Finally, we’ll cover program expenses, explain the implications for bookkeeping, and make available a cheat sheet to help you with coding functional expenses.
Cost vs. Expense
Cost most closely equates to “expenditure,” meaning an outflow of cash or other resources from your organization. A cost may or may not be treated as an expense in the same time period. For example, you may incur a cost for the purchase of officers’ and directors’ insurance, but you treat as expense the percentage of the policy term used up during the organization’s fiscal year. You may incur a cost to buy new computer equipment, but you only treat as expense the portion of the equipment that is depreciated each year.
Be careful – often the words “cost” and “expense” are used interchangeably. Be sure you know the difference and understand the context in which they are used.
Fundraising vs. Overhead
In our last post we listed “fundraising expenses” as a term that can be confused with overhead. Generally we believe it’s more appropriate to use the word “overhead” in connection with management and general expenses and to not use overhead to refer to fundraising expenses.
Then again, we feel it’s best not to use the word “overhead” at all since it has such negative connotations. Besides, everyone interprets overhead differently. So, while we want to understand everything that overhead can mean, we will strive to be more precise and more positive in our choice of terms.
Every nonprofit that raises money from contributions likely incurs fundraising expenses. It’s possible these expenses are quite low, especially if the organization is being run by volunteers. However, fundraising expense is unlikely to be zero.
In 2004, the Urban Institute Center on Nonprofits and Philanthropy at Indiana University conducted a study of over 250,000 IRS Forms 990. What they found was shocking. 37% of nonprofits with at least $50,000 in contributions reported zero fundraising expenses. 25% of nonprofits reporting $1 to 5 million in contributions reported zero fundraising expenses. While this study is getting a bit old, we think it still speaks to a core problem, especially among smaller nonprofits that can’t afford professional help. Nonprofit leaders and donors often lack an understanding of what constitutes fundraising expenses.
Fundraising Expenses per Form 990
Per the instructions to Form 990, “fundraising expenses are the expenses incurred in soliciting cash and noncash contributions, gifts, and grants. Include expenses related to
- Publicizing and conducting fundraising campaigns
- Soliciting bequests and grants from individuals, foundations, other organizations, or governmental units that are [considered to be contributions].”
Fundraising Expenses per Generally Accepted Accounting Principles (GAAP)
Per GAAP, fundraising activities (and therefore the related expenses) include:
- Publicizing and conducting fundraising campaigns
- Maintaining donor mailing lists
- Conducting special fundraising events
- Preparing and distributing fundraising manuals, instructions, and other materials
- Conducting other activities involved with soliciting contributions from individuals, foundations, government agencies, and others.
In its discussion of joint costs (ASC 958-720-45) GAAP clarifies that activities to educate the public about “the causes, conditions, needs or concerns that a non-for-profit entity’s programs are designed to address” are presumed to be fundraising unless other factors are present that would allow the expenses of those activities to be considered joint costs. We have often seen networking and other promotional or outreach activities meant to publicize the good work of an organization to potential donors classified as program expenses. However, they are considered to be fundraising expenses unless other elements are present. We’ll cover joint costs another day!
Note on Expenses of “Special Fundraising Events”
Expenses of fundraising events are treated differently than other expenses. In Form 990 the direct costs of conducting the event are presented as an offset against the income from the event, resulting in a presentation of net income from the special event. This presentation is important because it places special event expenses into the report of income, and keeps it out of the statement of functional expenses. This treatment is similar in audited financial statements. The benefit to you is a reduction in the total presented as fundraising expense. Here is one accounting convention in your favor!
Fundraising Expenses We Often See
In practice, for our nonprofit clients, we find fundraising expenses often include:
- Allocations of indirect costs (common costs) related to fund development
- Payroll expenses for the executive director and other staff based on use of time
- Expenses associated with a physical building or office based on allocation by square feet
- Depreciation, based on use of the related assets
- Office expenses and information technology, based on use of staff time
- Direct expenses
- Annual fees to renew the state registration to solicit contributions
- Expenses of soliciting and thanking donors, such as travel, postage and printing
- Fees paid to a grant writer or fund development professional
- Chamber of commerce memberships and other networking expenses
You may incur other fundraising expenses; this is just a list of expenses we see often. If your nonprofit incurs these types of expenses, you should report them as fundraising.
Congratulations! You survived our explanation of fundraising expenses! It’s OK with us if you take the rest of the day off. In our next post we’ll explain management and general expenses, then program service expenses last. We’ll also cover approaches to tracking functional expenses in QuickBooks. We’ll even have a cheat sheet for you to help with bookkeeping. We bet you can’t wait!