The functional expense analysis was once a requirement solely for voluntary health and welfare organizations, leaving many nonprofits happily on the sidelines when it came to reporting functional expenses. With FASB’s issuance of Accounting Standards Update (ASU) 2016-14, Not-for-Profit Entities (Topic 958): Presentation of Financial Statements of Not-for-Profit Entities, all not-for-profit entities are now required to present the relationship between functional expenses (such as major classes of program services and supporting activities) and natural expenses (such as salaries, rent, electricity, supplies, interest, and depreciation). For financial statement users, this analysis will provide a more in-depth look at how nonprofits spend toward their missions. For auditors and preparers, it will necessitate at least some rethinking of the approach to the allocation and reporting of functional expenses.
The new standard leads to three key questions with respect to functional expense reporting that will need to be considered carefully.
1. What, exactly, are management and general expenses comprised of?
A typical first question may be: What expenses can a not-for-profit reasonably pinpoint as specific to a certain function? ASU 2016-14 sharpens our focus by providing guidance on which expenses should be allocated to management and general supporting services.
Take human resources, for example. Some organizations allocate departmental expenses for payroll and benefits administration across program and other supporting services, thinking that human resource activities support all functions. However, ASU 2016-14 clarifies that human resource activities support an entity as a whole and, therefore, should remain in management and general activities.
Budgeting, finance, and general oversight or business management also are management and general activities that would not be allocated to other functions as clarified by the new standard. On the other hand, the standard describes specific cases in which costs of activities that constitute direct conduct or supervision of program or support functions would be allocated to the program or support functions that receive a benefit. Auditors and preparers need to be familiar with the clarified guidance and the specific cases and examples for expense analysis and reporting provided by ASU 2016-14.
2. How are expenses allocated?
GAAP does not specify the methods that may be used to allocate expenses, instead leaving the selection of allocation methods to the judgment of management. Auditors will need to understand how management chooses to allocate expenses and evaluate the methodologies for reasonableness. Using a reasonable allocation method consistently over multiple reporting periods is extremely important to the fair presentation of expense information.
Consider, for example, the allocation of an officer’s compensation and benefits. A rational methodology to allocate these expenses could involve using hours spent on the direct conduct or supervision of programs and supporting services, which could be obtained from the nonprofit organization’s timesheet software, time studies, or estimation. However, for another type of expense, say rent, a nonprofit may allocate the expense based on the square footage of space used for programs and supporting services. Auditors will need to inquire about the controls in place over the determination of allocation methods, whether the methodologies are reasonable, and whether those methodologies have been consistently applied.
3. What are the requirements for reporting and disclosing expenses, and is there flexibility in how this may be done?
ASU 2016-14 requires all not-for-profit entities to report information about all expenses in one location—on the face of the statement of activities, in the notes to the financial statements, or in a separate statement. Investment expenses that are netted against investment return may not be included in the analysis. The following are important considerations for nonprofits that are evaluating their choice of location:
- Within the Statement of Activities – If a not-for-profit selects this option, the statement needs to be easy to follow. Only very small, simple entities are likely to use this option.
- Notes to the Financial Statements – When using this format, it is important to include appropriate references, so that the schedule’s place in the footnotes is clear.
- Statement of Functional Expenses – Complex entities may want to consider this option for clarity.
- Note that presentation as supplementary information is not permitted.
Regardless of the format and location chosen, the methods used to allocate costs among program and support services must be clearly described in the footnotes. Inadequate disclosure is an error, and as usual, risk increases when new disclosure requirements are imposed. Auditors and preparers will need to pay careful attention to how allocation methodologies are described. FASB ASC 958-720-55-176 and Note F in FASB ASC 958-205-55-21 provide useful examples of note disclosures of methods used for cost allocation.
The allocation of functional expenses requires careful consideration and professional judgment. With the release of ASU 2016-14, auditors and preparers need to take a closer look at the potential for misstatement due to flaws in the models. Auditors also will need to consider the risk of fraudulent reporting, as the pressure on not-for-profit entities to minimize general and administrative and fundraising and development costs is ever present.
For additional information or answers to other questions on functional expenses and other nonprofit accounting and financial reporting topics, visit the AICPA Not-for-Profit Section’s Audit and Accounting FAQs. If you missed the first part in this series, be sure to read: 4 steps to improve nonprofit functional expense reporting.