One of the stickiest aspects of accounting for not-for-profit (NFP) entities involves allocations — how these entities account for where they spend the funds they receive.
For-profit businesses don't have to worry about this too much. If you have a pizza parlor, it doesn't matter if you use the profits from your pizza sales to pay the rent and the profits from your soda sales to pay the utilities (or vice versa). The customers don't care what you do with their money, as long as they get their pizza and their drinks.
It's not so simple at an NFP entity.
How You Got the Money Can Determine Where You Spend It
Many NFP entities receive funds that are earmarked for specific purposes. For example, let's say an organization receives a grant expressly to provide wheelchairs for the physically challenged. The organization can't use that funding to sponsor an event instead. They have to spend it on wheelchairs — and they need documentation to prove they did. (This is called "direct identification.")
Allocations can get incredibly granular. If, for example, an NFP entity decides to include information about both an upcoming fundraiser and an annual membership drive in the same mailer, they actually have to break down the percentage of the mailer devoted to each purpose to properly allocate funds. (These are considered indirect allocations.) If 30% of the mailer is about the fundraiser, then 30% of the cost should come from the fundraising budget. The remaining 70% comes from the membership-drive budget.
How does the NFP entity calculate those percentages? That's where the guidelines toggle from precise to vague. (Speaking of vagueness: There's a subtle distinction between an NFP entity and nonprofit organization.) A recent Accounting Standards Update from the Financial Accounting Standards Board (FASB) says only that each NFP entity's method of allocation has to be "reasonable."
Setting the Standards
So what's "reasonable"? Whatever method an NFP entity chooses to determine its allocations, the key is to apply it consistently. If, in our example above, an organization determines the percentage of the mailer devoted to fundraising based on the number of lines, they need to do that with all mailers. Or they can use the number of words as a determinant. Again, consistency is the key.
Other key takeaways from the recent update include:
- Make sure allocations are accurately calculated. Breaking down the allocation of every dollar an NFP entity spends is painstaking but necessary.
- Make sure management reviews all allocations. Given the complexity and importance of accurate allocations, this is a task that should require high-level sign-off.
- Document your allocation plan and circulate it to all involved. When it comes to allocations, everyone needs to be on the same page — literally.
- Make sure all expenses fit the scope of your organization. NFP entities are governed by strict guidelines. You need to adhere to them or risk trouble with the IRS. Use a critical eye to compare your expenses to those of similar organizations, and be sure you're in line with accepted standards.
We've barely scratched the surface here. The FASB's Accounting Standards Update on this topic consumes 270 pages — and even then, the report concedes that "The amendments in this Update make certain improvements that address many, but not all, of the identified issues about the current financial reporting for NFPs." So stay vigilant.