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Basic invoice example for non-profit organizations

Thank You Emily so today we're going to be discussing nonprofit cost allocations have been a wet nurse EPA's for 14 years working with nonprofits during their time as a matter of fact I just checked and today is my exact 14 year anniversary and well congratulations I can't think of a better way to celebrate than to discuss the cost allocation of nonprofit organizations so here we go we're going to divide this presentation into three parts we're talking about cost allocation for financial statement purposes for IRS 990 purposes and for allocations to federal awards so the first part involves cost allocations for nonprofit financial statement purposes and just as a general overview the expenses of a nonprofit can in general be broken out into two different dimensions we have our functional expenses functional expensive classifications which explain why an expense was incurred and our natural expense classifications tell a story of what was incurred natural expenses are generally going to be pretty much the same categories across most all nonprofit organizations they are things like personnel costs occupancy costs which are rent and maintenance for those who rent their space or interest mortgage interest and appreciation for those who own their space also things like supplies friend ding postage accounting travel information technology those are natural expenses that are fairly similar across most all nonprofit organizations if we take a look at the functional expenses the functional categories are generally accepted accounting principles or we just abbreviate it as GAAP sets up for basic functional categories program services measure the general fundraising and membership development once they once again the functional categories are the why that an expense was incurred the last three of these management of general fundraising and membership development are known as supporting activities the program services are really those expenses that are incurred to support the purpose or the mission of the nonprofit you really those are serving the nonprofit's members or beneficiaries these are the things that you do because you want to do them whereas management in general expenses are the things that you don't really do that because you want to they're more done of necessity for the overall administration and governance of the nonprofit well I take that back maybe I'm counting you do just for fun but the other ones you do because they're necessary to do to administer the overall nonprofit the last two classifications are fundraising and membership development and kind of at a high level you can think of fundraising costs are those costs involved with soliciting contributions or soliciting money and membership development costs are those costs incurred to solicit members most nonprofits do not have membership development costs those are fairly well geared towards some specific kinds of nonprofits such as trade associations or unions many nonprofits that have what they call members in their organizations aren't really members for this particular purpose you only have membership development costs if you have members in which the membership incurs specific duties or is entitled to specific benefits if that's not the case then really the costs of getting members for a non-profit it's probably a fundraising costs and not a membership development cost another way we want to think about costs of a non-profit is the distinction between direct costs and indirect costs direct costs are those things that are clearly identified with a particular purpose or objective there is no cost allocation involved with a direct costs of a non-profit you just assign it directly to that function you say this is a direct function of program or management or fundraising and if there are indirect costs these are the costs that are really at the heart of cost allocation these are things that cannot be clearly identified with or directly related to a single objective or purpose these are the things that need to be allocated this is the biggest reason why the concept of cost allocation is necessary one of the things that we recommend as the best practice is when expenses can be specifically identified with a particular program service or supporting activity it's best if it's done if it's directly assigned to it first of all and as much as possible it's best if it's done early upstream in the accounting process right when that invoice is reviewed and approved and the invoice is recorded into the nonprofit's accounting system if you can assign that particular cost to a particular function that's great the more you can do that the less you have of indirect costs left over that need to be allocated so you're making your legs much easier if you can assign costs to specific functions early on in the process like one common example might be travel expenses if employees that current travel costs and those travel costs can be directly assigned to some particular function go ahead and do that early in the accounting process right when that invoice is approved or and/or recorded and into the accounting software if you do it that way then at the end of the day you have much less in unallocated travel costs that have to be allocated through the cost allocation system an important distinction to reiterate indirect costs are not the same as supporting activities this is something that even experienced accountants kind of stumble over and have to think about from time to time and indirect cost is something that can't be directly allocated and a supporting activity is something some particular function like management in general or fundraising and they're not the same thing for example rent is an indirect cost but it can be allocated to program services it's not necessarily just a supporting activity whereas accounting is not an indirect cost it's a direct cost and it's directly assigned to a supporting activity of management in general okay so now we have to delve into the area of indirect costs and how to best go about allocating them the basic overriding question should be thinking about when allocating indirect cost is what is the what is the overall purpose of the cost of why was the cost incurred in the first place and there are in general a few methods of going about assigning purposes to indirect costs the most common and probably the strongest method is based on a cause-and-effect relationship what activities caused the costs to be incurred if you can think about that that is that that's really getting you to the answer of how those costs indirect costs should be allocated among the different functions and having said that the most common universal method to allocate costs indirect costs to specific functions is the time relationship how much time do we estimate staff are spending on particular functions that's also known as the cost driver so we can estimate the amount of time that is spent in various functions and allocate certain indirect costs that way obviously the most appropriate indirect cost to allocate based on time would be personnel costs that need to be allocated another common cost driver would be the relative space or area of the that is used by the various functions like the relative square footage of the space devoted to different functions that could be a cost driver as well as a way to allocate some indirect costs and obviously the most appropriate indirect cost for that particular method would be occupancy costs there are other possible cause and effect relationships or cost drivers that are not traffic could use as well it could use for example the number of employees that that are devoted to particular functions as a basis for allocating costs indirect costs to those functions if there needs to be equipment maintenance costs allocated to functions the now traffic could determine how much the equipment is utilized directly by the various functions and allocated that way if some of the nonprofit's assets are insured and there are insurance expenses to be allocated it could allocated by the different ways those assets are utilized across the different functions so there are many different ways to allocate costs and as we'll see there is nothing Universal that we can definitively call the one and only right way to go about doing this there's another overall general way to allocate car indirect cost - which is based on the benefits received and what that mostly means is allocating indirect costs just based on the proportion of the direct costs that are assigned to each function so direct costs can be used as a proxy for allocating indirect costs this should only be used if indirect costs can be shown to benefit all the functions approximately the same amount and this is generally recognized that that method is not as strong as the cause and effect relationships methods methods but nonetheless it is it can be an acceptable method if you can justify that as an appropriate way to allocate your indirect costs so as I said before there is no one right best method any allocation method can work if it's rational rational I'm sorry reasonable consistently applied and well-documented does an organization have to have a written cost allocation plan for financial segment purposes the short answer is no it doesn't have to if if nonprofit is has a very simple set up and cost allocation is very straightforward and might be able to get away without having a written one but for cost allocations that have any kind of remote level of complexity if the nonprofit is audited by an auditor such as me and we find that there is no written cost allocation plan we will probably consider that to be a deficiency in internal control for not having a Costello written across allocation plan with a heavy one so that brings us to our first poll question is does your organization have a written cost allocation plan and will give about 30 seconds to respond just a few more seconds to ever to get your answer in okay the generally accepted accounting principles do not require you to have it I have a written plan like I said and generally except the kinetic principles one of the things that is required is to disclose in all financial reports that the preparation of financial statements involves estimates on behalf of management and estimates are a part of getting the finances State is prepared for most nonprofits the functional expense allocation is a very significant estimate so GAAP recognizes that cost allocation does involve estimates and that there's not necessarily one what and only one way to adequately do cost allocation for a given nonprofit all right let's take a look at some specific examples of how some cost allocation approaches might work for a non-profit here's a simple example of a non-profit expense allocation on the Left we have these accounts which are the natural expenses and going across the top of the page are the functional expenses program services management general and fundraising many nonprofits will have multiple program services so you don't have to have just one and then at the far right we have the indirect costs so these amounts were able to be directly assigned to these functions because they directly relate to a particular function and these indirect costs are not directly related to a particular function so they need to be allocated one way to do it would be to allocate the indirect costs all on the basis of time there may have been what we call a time study done to determine that the staff time was spent 69% of program activities 27 percent of management general and 4% on fundraising when I first started doing accounting work I would hear the the phrase time study and I didn't really understand what that meant I thought maybe a time study involved somebody following staff around all day long and jotting down exactly what they did that's not really what a time study is all about a time study is more about taking the records that already exist with respect to how staff record their time and analyzing it so analyzing the historical information about the staffs self-reported time allocations is really what a time study involves so in this case we had we determined that or we I guess the better way to put it is we estimated that on the staff time is spent among these particular functions on those percentages so we're going to take the indirect costs and allocate them to the different functions based on these percentages and so we can move all the internet costs to the functions and then we have our total of the each functional category that includes the indirect allocations if we take that same non profit there's same basic financial information another way we could do the cost allocation is to say that well for personnel costs were to do that same time allocation as shown in the previous slide but for these other indirect costs office supplies rent and utilities we're going to allocate those based on the relative square footage of the facilities that are utilized for programs services management general and fundraising and in this case we determined that about sixty seven point five percent of our space is used for program services twenty percent for management general the 12.5 percent of fundraising and so that's how we're allocating these particular indirect costs into these functional categories and so we have this total result for the functional categories the totals here are a bit different than the totals of the previous slide which way is better or more appropriate well there is no real correct answer to that it all depends on the situation and what management feels is of the best nothing I will say that sometimes we've we've noticed that people or which I should say nonprofits over utilize the time estimate as a cost driver for all indirect costs when maybe that's not the most appropriate way to do it so this may be a common pitfall that we see is over reliance on the time estimates as a way to allocate costs for all the internet costs but having said that it's not necessarily the wrong approach in all cases and the last component of the cost allocation for financial statement purposes that we'll go over it involves the special area that gap has curved out to account for joint costs joint costs are the costs of fundraising activities that also might have another functional component associated with them the authorities apparently felt that there was too much of a tendency for nonprofits to be tempted to over allocate fundraising activities to program services and so they decided that fundraising activities really need to be a series of tests in order for those costs to be allocated if those tests are not all met then the default conclusion is that all the fundraising costs have to be assigned to fundraising so the three tests are the tests of purpose audience and content the purpose test the first tests in the third test content those are pretty straightforward does the fundraising activity include programs service or management functions in addition to fundraising functions and for the content tests does the activity support program content as well as manage or management in general content as well as a fundraising content so those are pretty straightforward and the answer to both those questions has to be yes for fundraising costs to be allocated to other functions as well as fundraising the site the the final test is that the middle one the audience test which is the most difficult one to beat in many cases if the audience for the fundraising activity includes prior donors or if it was selected even in part based on the ability or likelihood of members to contribute money to the nonprofit then the assumption is is that the nonprofit has failed this test and it cannot allocate those costs to anything but fundraising so if the audience does include prior donors or likely future donors but not profit you have to demonstrate that this was not a significant factor in selecting the audience in the first place so if the nonprofit meets those three tests for a fundraising activity those costs can be allocated to functions beyond fundraising if it doesn't meet those tests all the costs have to be assigned to fundraising all right we're move on to part two which is cost allocation for IRS 990 purposes there is a particular part of the 990 part 9 that has to be completed by 501 C 3 and 501 C 4 nonprofits that is essentially a schedule of allocating expenses among different functional categories not all nonprofits even if it's a 501 c3 or c4 not all that profits have to file a full 990 or relatively small ones can file a 990 easy which is a simpler form and does not have this schedule of functional allocations so that brings brings us to our second poll question what is the size of your nonprofit is a are the annual revenues less than 1/2 million are they between 1/2 million and 1 million between 1 million and 5 million or a greater than 5 million or are you just not within that profit so we'll give you a few seconds to answer those net wishing the IRS instructions say that you should use your normal accounting method to complete the schedule so if you're a nonprofit that has already done the cost allocation appropriately for financial statement purposes as we reviewed in the first section then you already have a sound basis for for complete even of the 990 per night if you don't have financial statements that have a cost allocation done then you can use any reasonable method of allocating the costs the IRS doesn't explicitly say that you have to use methods prescribed by GAAP you certainly that's certainly a safe way to do it but if the IRS stops short of explicitly say me happy because L occasions have to be done ing to generally accepted accounting principles the Wunder first between the IRS Form and the gap method is that the IRS only has three functional categories program services or program management general and fundraising for GAAP purposes there was that fourth one called membership development if there's a membership if an organization has membership development and does need to fill out a 990 because it's a c3 or c4 then those costs need to be allocated to what are the other functions in the most common way we see that happening and in what is a perfectly acceptable method is for those costs to be allocated reallocated to the management and general function many nonprofits that have the membership development costs in their financial statements are not 501c3 SRC fours in the first place and so they don't need to have that allocation done because the night that part of the 990 doesn't apply to them the IRS has some preset categories that it lists on part nine and so to complete them that part properly we need to put our expenses into the IRS slots and that could evolve from recombining some of our expenses into the IRS is natural categories or if we have some important categories that are not part of the IRS is preset natural expenses we can add them to the IRS expense categories on that very pertinent schedule and there are some expenses which do not go on the IRS functional expense part nine because they're moved to a different part of the 990 rental expenses that are associated with rental income activities cost of inventory sold direct expenses of fundraising events and gaming expenses these are all moved out of the functional expense part of the 990 and they're put into part eight which is an essentially a deduction from revenue that's how they're categories in the 990 and the last two expenses the expenses related to fundraising and gaming if those if gaming in the fundraising events were significant they also go on a separate schedule called scheduled G the IRS does make it clear that there are some kinds of expenses which in some circumstances can be considered to be program services even though it might not be obviously the case if lobbying is part of the purposes of the nonprofit lobbying expenses can be considered to be a program expense costs to obtain Awards used for program services can be considered to be a program expense and cost related unrelated business activities in some circumstances can be considered a program expense and related business activities are associated with this thing called Ubud which is unrelated business income tax that nonprofits sometimes have to incur if they do activities that are not related to their nonprofit function so if there is a if there are unrelated business activities and an unrelated business income taxes though those activities in some circumstances can be considered a program expense so even though this might not be these might not be obvious program costs the IRS does allow them to be considered program expenses for 990 purposes in some circumstances the IRS also has this lovely thing we saw earlier called joint costs joint costs here are not exactly the same as what was discussed for financial statement purposes here the joint costs are have a bit more of a narrow definition the joint costs here are costs that are occurred from combined educational campaigns and fundraising solicitations so that's a that's a bit narrower of our definition than what we saw for gap for their favorite purposes so if nonprofit does have these drink it needs to disclose them at the bottom of part 9 of the 990 and also disclose how the join costs were allocated so that's the basics of the 990 and sorry the cost allocation for IRS 990 purposes now we're going to move on to a cost allocation for government to work purposes which is one of the areas I know that people are most concerned about the authoritative guidance for many years was this publication put up by the government called the OMB circular a-133 organizations that has as if a few years ago has now been subsumed into this this other publication called the uniform guidance in now both terms are still used in the accounting world you'll see references both to circular 1:8 a circular a 122 and to the uniform guidance and many people including accounts use those terms fairly interchangeably the a 122 rules although they're established for federal awards many other government entities follow these same principles Dane County which is where Wegener is based in probably many of the participants of this webinar are located Dane County explicitly references a 122 as it's for its you know allowable costs and cost principles the most important point that we can really emphasize with respect to allocating awards sorry allocating costs to government awards is that you cannot allocate it based on how much unused funding and award still has I know that's tempting but that's the probably the biggest red flag and nonprofit can do is to decide to put costs to a federal ward or to any government award just because the award needs funding or our needs cost us assigned to it so that all of this funding can be properly accounted for it's also the case that all cost allocation plan all federal awards need written cost allocation plans remember as we discussed for financial statement purposes just for perd just per GAMP a written cost allocation plan is not an absolute requirement well it is a very clear explicit requirement for recipients of federal awards you have to have a explicit cost allocation plan that you're following and if you don't have that that will almost certainly be a finding that your auditor will dingy with during the course of an orange one of the important points about allocating costs to federal awards and probably any government governmental award is that the costs need to be reasonable and that generally means to be they must be ordinary and necessary in the context of that nonprofits business activities and they must be adequately documented if the costs are not adequately documented and the government should never check up on if the award was properly utilized things that are genetically documented are basically the same as not having been incurred at all and so the government would probably not consider that cost to be to have much of a rational basis for existence it was not adequately documented for federal allocation methods there are a couple basic starting points for methods that are allowed by the government some of the methods we start with allocating the costs into direct I'm sorry allocating the or assigning in the direct costs into particular costs objectives and then allocating in indirect costs to those cost objectives and we'll get to these I mean just a little bit the uniform guidance says lists of few methods that are explicitly allowable which are known as the simple simplified allocation method the multiple allocation based method and also the use of specific indirect cost rates another method that the uniform guidance says is acceptable is called the direct method and we'll get to that too that's we started with a different set of numbers using the direct method than we do with the other meds so once again we have to start with making the distinction between direct costs and indirect costs and direct costs here has a bit of a different meaning than direct costs did for financial statement purposes here direct costs are things that you can directly allocate to any particular award or another any other kind of direct activity of the nonprofit the direct activity is if it's directly identified with serving but not travis numbers clients or the general public it should be assigned as a direct activity in fundraising costs are also direct so basically anything that can be considered to be a direct direct objective of the nonprofit should be assigned a as a direct activity for these purposes and just like we discussed with financial saver purposes any expense that can be allocated to an award should be directly allocated to that award early on in the process the earlier you can assign a cost to a particular award the better less allocation you have to do further down the road and just the easier your life is all around so thus there's the first method that the you firm guidance says is acceptable is to take fill those indirect costs which were not assigned directly direct cost in the first place and then just allocate to the direct allocate to the direct categories proportionately by some logical rate um this is a fine method if all the major functions benefit to by approximately the same degree if they benefit from the indirect cost by approximately the same degree this is the fine method the important point to let the last point is that you have to take those two indirect costs and you can't just allocate them to the the words you have to allocate them to all the direct cost categories and what will it show an example of that a bit later the middle two dots are really language that's taken from the uniform guidance that show them that discuss the specific mechanics of doing this process but a basic summary is what we have appeared you allocate to the indirect costs to the direct categories proportionately by some logical rate you might be in a situation where you have to use a multiple allocation based method because for example the indirect costs are not benefiting each category by the by approximately the same amount so you want to do the different methods such as the multiple allocation based method and this basically says you then your indirect costs you put into two different indirect costs categories or pools and those indirect costs categories or pools are then allocated to the direct categories by different methods and those methods that the indirect costs categories should be allocated to the direct cost categories are prescribed by the uniform guidance if you want to take a look at that another way to allocate costs to federal awards is to just use a simple specific indirect cost rate the this is the easiest of the methods that we discussed so far you can one way to get an indirect cost rate is to negotiate with what is called the cognitive agency the federal agency was the largest dollar value of the awards for the nonprofit or you can use a default de minimis 10% indirect cost rate if you want in which case you don't have to do any negotiations with any federal agencies you just supply the 10% rate and that's about it so like I said this is the simplest way to do it you just add the percentage of indirect costs to the red cross sign of the award and you're done okay so before we get to the example so let's take a look at the direct method is it's basically a different starting point than the other three methods that we just went over you start with costs that have already been allocated essentially for financial statement purposes the uniform guidance doesn't doesn't explicitly say that you start with your financial safety allocations but it says that that the allocations are compatible with the approach you used for financing of versions so it seems that if you have allocations done already for your financial statements that's a perfectly fine starting point and then what you're going to allocate is basically your general costs or your management general costs in the financial statement context that's when you allocate to your direct activities and once again those are done by some rational a reasonable method alright so that was quite a bit of jargon and I don't I doubt that you are all able to follow that precisely so let's take a look at some specific examples that might be somewhat helpful oh I'm sorry Emily I forgot the the third poll question we are discussing um indirect cost rates that you could use to allocate your indirect costs to federal words and the question is does your nonprofit use an indirect cost rate for federal words do you use a rate you've negotiated do we use the default diminish the minimis 10% rate or do you not use an indirect rate or are you not associated with nonprofit look at everybody just a few more seconds to get their answers in I've received a couple of comments on the chat about the poll question not showing and I've responded to the two that I know have been having issues but if that's the case please let us know and send us your responses so that we can still give you key credit if you're looking for that okay good so let's move on to some specific examples here is how particular costs might be preliminary assigned to either as direct costs to specific Awards costs that are unassigned these are serving the nonprofit's mission their fare is fairly synonymous with program service costs that just haven't been allocated or assigned to a particular award and fundraising costs this nonprofit was able to directly assign certain costs to these direct categories preliminary and now it has these indirect costs which it was not able to assign directly to those categories and it used to allocate for award purposes let's say it wants to do the simple simplify and allocation method and one way it could do it would be the based on the relative amount of direct costs that each of the direct categories incurs so we have $120,000 of indirect costs that should be allocated in the total amount of the direct costs is 300,000 so that means our indirect cost rate is 40 percent so when I take these indirect costs and allocate them to each direct category by a rate of 40 percent and so that's how we allocate the full hundred twenty thousand dollars the important thing to point out here is that you can't just take the hundred twenty thousand and allocate it to the two awards it has to be allocated to all the functions of all the direct functions including the awards so you have to allocate it proportionally to things that are unassigned and to the fundraising category along with the the awards so I hope that makes sense is a very important point another way the same nonprofit could have approached it using the simplified allocation method once again would have been on the basis of direct wages so once again is taking that full hundred twenty thousand dollars of minaret costs and thus allocating it to the different functions based on the relative amount of direct wages in this case the total direct wages was 250,000 and the indirect cost was 120 so it's a 48% indirect cost rate in this case fundraising doesn't get anything allocated to it because it didn't have any fundraising personnel costs that were directly assigned to it in the first place so we're allocating the full 120 once again to the different direct categories and once again you can't take the hundred 20 and allocate it just to the awards you have to allocate it to all the categories that had director wages in this case so in this case you have the awards and the unassigned amount so we if the result is in under this method we have an award a of 268 in the board B of the liver 106 that's been different then the approach we had in the previous slide which has aborted getting to 57 and we're beginning hundred twelve either method is valid and acceptable provided that it's rational reasonable supported by a written plan and consistently applied now let's say the same nonprofit just decided to use and the de minimis 10% indirect cost rate and didn't want to take any of the other mathematical steps so this very simple method you just take the direct amounts and then you add 10% to those totals and then you have the total amounts that are associated with different awards and other functions this in this particular example the award amounts allocated or the most allocated to awards a and B are both lower than what we saw in the other methods so you actually you actually have a significantly lower amount allocated to both award a and award be that might be okay let's say the total magnitude of the award a was only $200,000 and the magnitude of Ward B was only 85,000 well just by applying this 10% in direct allocation rate you've already covered the full amount of the awards and then and so you're done so it might not it might be it for a perfectly fine approach to use a indirect cost rate such as this in some cases and then the the other method we'll take a look at is the direct method and once again this has a different starting point than the other methods the starting point here um it looks pretty similar to what we saw back on a previous slide when we way back when we were talking about cost allocations for financial statement purposes we have these categories award A or B and unassigned which are essentially the program services then we have the general expenses which for called management in general back in the financial statement section and our fundraising and so the goal here is to 'simply allocate these general expenses to the different categories award a award be an assigned and we in this case we decided to do that by on the proportion of direct costs relative to all the costs it turns out that the cost right here general expenses are 35,000 direct costs 3 or 85,000 and so we use a 9% rate and that's how we allocate to the awards very importantly we can't just allocate to the awards we also have to allocate you know that in that same proportion to the unassigned the unassigned category and the fundraising category and so we end up with these amounts for amongst allocated to the specific awards so like I said the the big things to keep in mind for federal allocations are number one you can't the worst thing you could do would be to take this 35,000 and allocate it to award a or or be based on how much unfunded amounts those award has that's that's the worst thing we do and another thing you could do that's still not acceptable will be to take the $35,000 and allocate it just to awards a and B um you have to allocate it also to all of your direct categories not just the things that are not just the cost subjects that are the awards so that is the conclusion of the presentation and I hope that you come away with us with a good appreciation for the basic concepts of cost allocation and maybe even realizing that the whole process can be a bit more enjoyable than you originally thought - awesome well thank you so much Brian that was a ton of information and super helpful just a reminder to all the attendees that you will receive this presentation along with the recording of today's webinar after today's event if you do have any questions Brian's information is right here on the screen so feel free to reach out to him we so appreciate all of your time today Brian do you have anything else to add fine arm works um so far today is been a wonderful 14 year anniversary awesome well thank you so much and thank you all so much again we hope you can join us for upcoming webinars we have another non profit roundtable at the end of the summer and we have a couple on PPP loans tomorrow so if they do again and enjoy the rest of your day it's Friday thanks melody