Understanding Functional Expenses – Part 4 of 4
This post is the fourth and final (but probably not the last) in a series of posts on functional expenses. Actually five posts if you count the introductory post, Demystifying Nonprofit Overhead. Here’s a quick overview of the topics in each post:
Demystifying Nonprofit Overhead: Deconstructed the term “overhead;” why you should care about it.
Understanding Functional Expenses – Part 1 of 4: Cost vs. expense; fundraising expenses.
Understanding Functional Expenses – Part 2 of 4: Direct vs. indirect costs; management and general expenses.
Understanding Functional Expenses – Part 3 of 4: Program service expenses; impact of ASU 2016-14
Today we are ready to tackle what all this means for your day-to-day bookkeeping.
Functional Expenses and Bookkeeping
The upshot of functional expense reporting for bookkeeping is that you need to code each expense two ways, by:
- Natural classification – by account in the chart of accounts such as salaries & wages, rent, travel or office supplies and
- Functional classification – by class (QuickBooks uses classes; other software use tags) representing a specific program, management and general, fundraising, or special event.
There is not a “one size fits all” approach to keeping track of functional expenses in QuickBooks or other bookkeeping software. Nonprofits may prepare detailed allocations in QuickBooks monthly or wait until fiscal year end before separating expenses by functional area using Excel. The level of detail for monthly work also varies. And much judgment is called into play in determining how to code various expenses. The key is to find a system that works for you. Accounting is always a trade-off between accurate, detailed information and the cost of preparing that information.
Tracking expenses by functional area in QuickBooks opens up the possibility of recording income by functional area as well. This information is very useful for management purposes and may also be helpful for audit and 990 purposes. For example, you can track how much income is attributable to a specific program. Once you know how much of the program’s expenses are covered by service fees and gifts restricted for that program, you can determine the amount of unrestricted income needed to completely cover the expenses of program delivery.
The Classes You Need in QuickBooks
A useful bookkeeping technique in QuickBooks is to create classes as follows:
- Each major program area
- Management and general
- Each major special event (Form 990 requires details of special events with gross receipts > $15,000)
- Common Costs
Be careful not to create too many classes. It may be tempting to create a class for every sub program, but keep in mind somebody has to make decisions about how to enter expenses to these classes. The more classes you have, the wider the Profit & Loss by Class report becomes which makes it more difficult to read. Also with too many classes it becomes harder to code transactions accurately. Accounting is a balance between summarizing data and providing enough detail to be useful.
The general rule is to code expenses (and income) to the proper account and class if the transaction directly pertains to a class. If the expense is an indirect or “common cost” then code it to the proper account and the Common Costs class. Spread common costs by journal entry to the other classes on a periodic basis, usually monthly.
Allocations for Common Costs
Before you can allocate common costs, you need to determine what those allocations are. Common costs are usually allocated based on use of staff time or use of space. For use of staff, develop a list of staff and annual compensation, then spread each person’s compensation over the classes using percentages that relate to use of time. For use of space, get a floor plan of your building and measure the square footage of the program areas vs. non-program or shared-use areas. For shared-use space, such as the executive director’s office, further break down the square feet using an allocation based on use of the occupant’s time. In the end you will have support for use of staff and space by program, management and general, and fundraising purposes.
Tracking Temporarily Restricted Funds (Advanced)
An advanced technique is to additionally create a class called Temp Restricted for temporarily restricted gifts and grants. As gifts and grants are spent on the restricted purpose, the restriction is released and the revenue can be transferred via journal entry from the Temp Restricted class to the class for the program or function that used the funds. It’s actually a bit misleading to initially code a purpose-restricted gift entirely to the program class the gift is restricted for. While the gift is considered to be income, it is temporarily restricted income until the funds are spent on the restricted purpose. Therefore it is more proper to code the gift to a Temp Restricted class and transfer in the gift support to the specific class(es) as the funds are used. This technique is especially useful for grants which may be spent in more than one functional area.
The Cheat Sheet You’ve Been Waiting For
We have prepared a “cheat sheet” called Guide to Functional Expense Allocations available under our Free Member Resource Library to help you with coding income and expenses to functional areas (classes), including templates to help with determining allocations of staff time and usage of space. If allocating common costs is too much, just focus on coding expenses directly to an appropriate class or to the Common Costs class. You will still save time and headaches for your external accountant at year end and be in better control of the financial picture presented by your organization.
This post wraps up our tour of functional expenses! We hope this series of posts will continue to serve as a handy reference guide for you. Be sure to sign up for our Free Member Resource Library and grab your free Guide to Functional Expense Allocations! And please let us know if you have questions or feedback for us.