Joint Cost Allocations Under Scrutiny by State Regulators: Avoid These Mistakes

Seven years ago, I wrote “Navigating Joint Cost Allocations: Top Five Mistakes to Avoid for the newsletter of the Association of Fundraising Professionals. In that article I pointed out common mistakes that nonprofits make in conducting joint cost allocations on their fundraising activities. In 2018, the allocation of joint costs on financial statements continues to be a key, and in fact, increasing area of scrutiny by state regulators who believe that charities use the methodology to inflate their program costs while reducing the publicly unfavorable expenses associated with their fundraising activities.

In several states, including New York, Michigan, and California, regulators have brought enforcement actions alleging that as a result of an incorrect allocation of joint costs, the charitable organization has in effect made materially false statements in the financial documents they submit as part of their required state reporting. This is despite the organization’s submission of audited financial statements verified by an independent CPA to meet generally accepted accounting principles (“GAAP”).[1]

In addition, these and other states allege that the use of incorrect allocations in solicitation materials is intended to skew the percentage of program versus fundraising expenses as an inducement to donors (think of the popular use of the Program vs. Fundraising/Administration pie chart in direct mail solicitations).  This, the States claim, constitutes deceptive fundraising practices and is therefore in violation of state charitable solicitation laws.

The common use of the phrase “public education and outreach” to describe program allocations in connection with the joint cost allocation methodology contributes to the confusion, because it seems to suggest that content which educates the public about the organization’s mission and programs constitutes an appropriate “program” allocation.  The fact is that only “call to action” content is allocable to program which I explain below.

In the years that have passed since I wrote the “Top Five Mistakes”, the AICPA rules have not changed, yet the same mistakes continue to be made and the misconceptions endure.  I hope this information will stimulate more meaningful communications between nonprofits and their auditors regarding this accounting principle, and ultimately lead to a more informed application of these complex rules.

Below is the text of the original article:

Although the charitable sector has long questioned whether fundraising ratios provide a meaningful measure of organizational quality, donors continue to focus on how efficiently an organization uses its funds to accomplish its mission. Joint cost allocation, a methodology for allocating the costs of fundraising activities when conducted together with program or management activities, is one tool that organizations can use to allocate as program expenses the portion of fundraising activities that are attributable to program accomplishment.  Unfortunately, joint cost allocation methodology is frequently misunderstood and misapplied due to its complex requirements.  This article seeks to demystify the process by explaining what joint cost allocation is, why regulators and watchdogs are concerned about it, and the top five mistakes that charities make when allocating costs of joint activities.

The American Institute of Certified Public Accountant’s (AICPA) issued Statement of Position (SOP) 98-2 twelve years ago, establishing a clearer set of financial standards for accounting for the costs of joint activities.  To illustrate, an activity in which the joint costs can be allocated is a letter sent to a prospective donor that asks for money but also seeks to engage the individual in fulfilling the charity’s mission through a “call to action.”  An anti-smoking organization, for example, may send a mailing that asks for a donation, but also includes various tips on how to quit smoking (i.e., a call to action).  By applying the principles set forth in SOP 98-2, an organization can allocate the cost of producing the letter between fundraising and program expenses.  This kind of allocation can be applied to the costs of a wide variety of activities, including direct mail, telephone solicitations, telethons, special events, and websites.

The IRS, state regulators, and charity watchdogs frequently scrutinize organizations’ allocation of joint costs as part of their review or investigation processes because they believe proper joint cost allocation helps ensure that organizations are fairly stating their respective fundraising, program, and administrative costs, and not misleading donors about their fundraising efficiency.  Tax-exempt organizations are required to disclose in their Form 990 whether they allocate joint costs, and if so, whether they comply with SOP 98-2. In addition, charities’ audited financial statements must similarly include notes explaining whether and how joint costs have been allocated.

Regulators and watchdogs generally pay closer attention to organizations’ joint cost allocations when more than half of the total joint costs have been allocated to program costs.  Some charities have avoided allocating joint costs altogether due to negative public perceptions that allocating joint costs could appear to be an improper way to boost the organization’s program expenses.  Other organizations have allocated joint costs, but because they do not fully understand the requirements set forth in SOP 98-2, the result may, in fact, be an unreasonable allocation, generally skewed in favor of program expenses. Both results are unfortunate.  SOP 98-2 was created to help organizations develop a reasonable allocation of the costs of their joint activities.  The accomplishment of an organization’s mission should not be ignored merely because they are carried out in conjunction with a fundraising activity.  When applied properly, SOP 98-2 should help an organization reflect its expense allocations more accurately, not less.  Below is a summary of the top five mistakes organizations make when allocating joint costs, and suggestions on how to properly and effectively apply SOP 98-2.

  • Not undertaking a preliminary analysis to determine whether the organization can allocate joint costs on a particular activity.

Organizations often skip over the all-important preliminary analysis, in which three criteria must be met in order for an organization to allocate the costs of a joint activity.  Those criteria are:

  1. Purpose: The purpose of the activity must be to carry out a program or management purpose. The organization should examine tangible evidence of intent (e.g., agreements, policies or other written guidance) to ensure that: (1) the organization intended to engage the audience in a call to action to help accomplish the organization’s mission, and (2) the majority of compensation of any party performing any part of the joint activity is not based on the contributions raised.
  2. Audience: The audience should be appropriate with respect to the action being requested. If the target audience includes prior donors, or is otherwise selected based on its ability or likelihood to contribute, a rebuttable presumption exists that the audience criterion is not met.  This presumption can be overcome if the audience is also selected because it has a reasonable potential to use the call to action, or it has the ability to carry out the call to action.
  3. Content: The content criterion is met if the joint activity actually supports program or management functions. For example, a mailing supports program functions by asking the recipient to take specific action that will help accomplish the entity’s mission (e.g., a mailing by a cancer organization advising the recipient on actions s/he can take to prevent cancer). Although the content criterion overlaps to some extent with the purpose criterion, the purpose criterion focuses on intention, while the content criterion looks at execution.
  • Failing to apply a systematic, rational allocation methodology.

Although there are various possible allocation methodologies, the most frequently used one is the physical allocation methodology, and the unit of measure typically used is lines (e.g., in a direct mail piece or television script).  Each activity must be separately analyzed.  For example, if an organization undertakes a direct mail campaign over the course of a year that includes six mailings, all six mail pieces must be analyzed separately.  It is not appropriate to analyze one activity (e.g., one direct mail piece), and attribute that line count to all of the other mail pieces.  It is also not appropriate to use a general estimated percentage (e.g., 60% program, 40% fundraising) based on gut instinct or some other unverifiable method of allocation.

  • Over-allocating educational language as program expense.

Many organizations make the mistake of categorizing educational material as program expenses when they do not call the recipient to take any specific action. Such allocation is prohibited under SOP 98-2.  For example, a statement that an organization’s mission is to fund cancer research, and a descriptive summary of the types of cancer research that the organization has helped undertake educates the audience about the organization’s cause, but does not engage them in any particular action, other than perhaps leading to a request for a donation to further support cancer research.  While the language itself may not directly be a request for funds, it also does not ask the audience to take any specific action that furthers the organization’s mission.  As such, those statements must be allocated to fundraising under SOP 98-2.  There is one exception in which educational language may have an implicit call for specific action. For example, activities that educate the audience about environmental problems caused by not recycling implicitly call for that audience to engage in recycling. In this case, the educational language may be categorized as a program expense.

  • Overlooking various components of the joint activity.

A joint activity may contain various cost components, and some organizations make the mistake of not accounting for some of those parts when conducting their joint cost allocation.  For example, a direct mail package may include a mailing envelope, a letter, an action insert, a premium item (e.g., greeting cards, address labels, etc.), and a business reply envelope.  Each part of the mail piece must be analyzed following a systematic and rational methodology.

  • Failing to find creative and meaningful ways to engage the audience.

Given a legitimate framework in which to allocate costs of a joint activity, organizations often fail to make the most of the opportunity to mobilize their constituents in meaningful ways that help the organization carry out its mission.  At a time when charities face fierce competition from thousands of new and old charities boasting similar missions, constituent engagement is a necessity for survival and success. Joint cost allocation is one tool that can support organizations seeking to encourage their audiences to get involved in fulfilling their missions and allow charities to fairly account for the costs of doing so.

For additional information on joint cost allocation methodology, please contact Karen Wu at Perlman & Perlman karen@nullperlmanandperlman.com.

This article was published in the January 11, 2011 edition of the Association of Fundraising Professional’s (AFP) eWire member e-newsletter.

[1] Joint cost allocation methodology was developed to comply with Generally Accepted Accounting Principles (GAAP). Joint cost allocation methodology, formerly known as SOP 98-2, has since been codified as FASB 958-720-05 through 958-720-55-170.

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