One of the major differences between for profit and nonprofit accounting is the method used to categorize expenses known as direct cost allocations.
Beginning with this post, Araize is launching a series of educational vlogcasts, combining a video lesson with a blog post. Episode 1 focuses on direct cost allocations and why your nonprofit needs to understand how it works.
How nonprofit accounting differs from for-profit accounting
Nonprofits are subject to a unique accounting requirement that requires the reporting of expenses according to the purpose for which they are incurred. Allocating costs to functional areas is the cornerstone of a nonprofit’s financial management and reporting. This process is one of the more challenging and misunderstood areas of preparing a nonprofit’s financial statements.
Financial statements prepared under FASB 116/117 break down expenses into the following functional categories: program and support services. Understanding the different functional categories is crucial to accurate functional allocations. We reviewed the importance and definition of functional expenses in a previous blog post.
Planning for your direct cost allocations
Now that you have an understanding of functional expenses, when it comes time to record the expenses incurred by your organization, you may need to develop a direct cost allocation plan to properly distribute expenses to the correct functional area. It is critically important to all aspects of your organization to have a defined allocation plan. The allocation of expenses will have a direct effect on your budgets, how you appear to donors, how you are reimbursed for expenses by funding sources, and provide critical data on the viability of your programs.
How direct cost allocations work for your nonprofit
A nonprofit organization pays their cell phone bill for $1,000. A for profit would simply categorize it as telephone expense as simply a cost of doing business. But, for a nonprofit, the bill needs to be analyzed to determine who has a cell phone and which department they work in. Upon inspection we determine that the Executive Director and Fiscal Director both have cell phones. The Development Director and his associate each have a cell phone. And finally, there are six phones used by employees in the After School and Day Care Programs. So the $1,000 cell phone bill is allocated to the following functional areas:
Management and General – $200
Fundraising – $200
Program Service Expense – $600
Now when reading the financial statements, we can easily see that the $1,000 cell phone expense was mainly incurred to support its mission, with a portion allocated to management and general and fundraising.
Tips for implementing your direct cost allocations
- Adopt and document an accepted allocation methodology, such as square footage for office space, children in care, and like the cell phone example, number of units to be allocated.
- It is important that the methodology used is documented so it can provide justification to auditors and the readers of the financial statements.
- Identify the expenses that are directly allocated to one of the functional categories, or that need to be allocated amongst several categories using an indirect cost allocation, which will be covered in a future blog.
- Keep timesheets for all employees, if their responsibilities overlap different departments and programs.
- Remain consistent with the functional and cost allocation plan. Review the allocation methodology on a periodic basis, and if necessary, make and document any necessary changes.
- Use an accounting system that allows for the segregation of accounts by multiple segments to allow for proper allocation and generation of financial statements.
Direct cost allocations are important because it can provide a true determination of your organization’s financial picture and how much each of your programs costs in relation to your support services. Your allocation method also determines the amount of program, management and fundraising that will appear on your Form 990 and other reports. This can influence potential donors on their decision to donate to your organization.
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