For some not-for-profit entities (NFPs), a separate statement of functional expenses will be the most efficient and effective way of presenting the analysis of expenses by function and nature that is required under FASB ASC 958. With that in mind, the following are some best practices for organizations to keep in mind as they prepare these schedules.
For natural categories, less is more. A common misconception is that U.S. GAAP prescribes a specific number of natural categories or a suggested format for the presentation of natural expenses in a functional expense schedule. That is not to say only one or two expenses categories should be presented, but as a preparer of NFP financial statements, you should carefully consider what level of detail is appropriate for the users of your financial statements. If you present 15-20 natural expenses categories, 1) they are probably too small to read, and 2) the level of detail likely is too granular for users. Consider reviewing the natural categories in your statement of functional expenses with materiality and user needs in mind. There isn’t a one-size-fits-all answer, but for the majority of NFPs, somewhere between five and ten categories should meet the needs of most users.
Programs should tell your story. The NFP financial reporting standards suggest disaggregation of the major classes of program services on NFP financial statements as a way of meeting the requirement to report expenses by functional classification. NFPs need to carefully consider which programs are separately disclosed. For some smaller organizations, particularly those of a specific charitable nature, it is entirely possible that there is only program. For example, consider a charitable organization whose mission is to provide grants for students to study a specific issue. If most of their expenses are grant-related and there are no other programmatic activities, it may be reasonable to take the stance that there is only one program. Conversely, for a large trade association, that stance would be more difficult to support due to the nature of their activities, which likely include providing services to members, advocacy on behalf of specific causes, conferences/conventions, and perhaps even ancillary ventures such as publishing. Determining the appropriate disaggregation will involve judgment, but an argument can be made that all of these areas represent major classes of programs. The point is that programs should tell the story of your organization. Take a step back before disaggregating and think about the mission and activities of your organization. This will help you get to the right answer.
Take credit for what your employees do. The NFP financial reporting standards have clarified an area of previous ambiguity in that certain expenditures, such as those related to accounting and human resources, should be reported as management and general expenditures because they benefit the organization as whole. This requirement may disappoint certain NFPs, particularly charitable organizations, that tend to be sensitive to ratings applied by watchdog organizations that may, in part, be based on the percentage of expenses that go to management and general. All hope is not lost though, as NFPs can still make an argument to allocate at least a portion of these expenses to program services if these employees spend time on programmatic matters. For example, if your chief financial officer spends time helping to develop strategy and implementation for a key program of your organization, that certainly is a programmatic effort. Similarly, if a human resource officer is involved in programmatic planning for the organization, that may also be an activity that warrants allocation to program services. The moral of the story here is to not assume. Before settling on an allocation methodology for certain salary expenses, hold discussions with your staff so that you can take credit for program service activities your employees actively participate in.
Review your allocation methodologies. Another requirement of the NFP reporting standards is to disclose the specific methodologies you use to allocate expenses to program and supporting services in your financial statements. NFP financial statement preparers should review their methodologies and ensure they are reasonable. For example, when thinking about salaries, timesheets are still okay, but an estimate of employee time, along with a memo or paper explaining the basis for allocation may be reasonable depending on the circumstances. For occupancy, office space by department or program may be a reasonable methodology. Whatever expense you are allocating, pause to consider whether a financial statement user would find your methodology reasonable, because it will be described in the notes to your financial statements.
Don’t forget about membership development costs. An area of frequent confusion and one that is often overlooked is membership development. To the extent your organization is spending time soliciting new members or communicating with existing members with no direct benefit provided back to them, those costs may qualify as membership development costs, which are reported in supporting services for purposes of functional expense disclosure. If you are a membership organization, you should analyze costs of this nature to determine if they require reporting in supporting services. If these costs are material to you and your employees spend a significant amount of time in this area, consider tracking employee time spent on a contemporaneous basis so the allocation of costs can go smoothly.