Functional Expenses

In August 2016, ASU 2016-14, Not-for-Profit Entities (Topic 958), Presentation of Financial Statements of Not-for-Profit Entities, (“ASU 2016-14”) was released, significantly changing the presentation of financial statements for not-for-profits. One such change within ASU 2016-14 is the requirement that all not-for-profit organizations present an analysis of expenses by both functional and natural expense classifications.

In the past, only entities that were considered “health and welfare organizations” were required to prepare a statement of functional expense. ASU 2016-14 requires that the financial statements contain an analysis of expense, which is provided in one location, either on the face of the statement of activities, as a schedule in the notes to the financial statements, or in a separate financial statement.

Nonprofit financial statements are often subject to public scrutiny, especially when they relate to the use of funds for programmatic purposes. By requiring a statement of functional expenses, the Financial Accounting Standards Board (“FASB”) aims to provide users of financial statements, such as volunteers, donors, creditors, and compliance departments, with relevant information to effectively evaluate how a not-for-profit organization is utilizing its available resources to fulfill their mission.

Natural vs. Functional Classifications

• Natural expense classification: A method of grouping expenses according to the kinds of economic benefits received in incurring those expenses. Some examples of natural expense classifications include salaries and wages, depreciation, and interest expense.
• Functional expense classification: A method of grouping expenses according to the purpose for which costs are incurred. These costs are generally classified as program services and supporting services.

The starting point for preparing a statement of functional expense is a schedule of expenses by natural classification. While this may seem somewhat straightforward, the implementation of ASU 2016-14 creates two matters of note:

1. Investment expenses (that are not for programmatic investing) must be netted against investment return and shall not be included in the analysis of expenses by nature and function. This means that, under generally accepted accounting principles in the United States of America (“U.S. GAAP”), nonprofit organizations are no longer permitted to report investment expenses, other than for programmatic investing, in the statement of functional expenses.

2. Report all other expenses by their natural classification. For example, if cost of goods sold appears on the statement of activities, it must be broken down into its natural classification of salaries, fringe benefits, and purchased goods. Furthermore, when special event costs offset special event revenues on the statement of activities, those special event costs must also be included in the natural classification, such as rent or food, in the analysis of expenses by nature and function.

The most common functional categories used for not-for-profit organizations are:

Program services – activities that result in goods and services distributed to beneficiaries, customers, or members, which fulfill the purpose or mission of the nonprofit organization. In other words, they are services that are for the major purpose and the major output of the nonprofit organization. In short, these are costs incurred directly for the organization to fulfill its mission.

Supporting services – supporting activities are all activities other than expenses included in program services. Supporting activities generally include management and general activities, fundraising activities, and member development activities.

• Management and general – costs incurred to run the operations of an organization that are not directly associated with a specific program, fundraising, or membership development activity.

• Fundraising – A fundraising expense is any expense incurred for the purpose of soliciting or securing contributions. Typically, when an organization reports contribution revenue, there is a presumption that it has related fundraising expenses.

• Membership development –Membership developments costs are similar in nature to fundraising costs, except they are incurred in obtaining an exchange transaction for revenue, in order to attract and maintain an organization’s membership base.

Allocation Methodology
Prior to ASU 2016-14, some organizations had a generic note that indicated expenses were allocated using percentages, and that management believes this is a reasonable approximation of actual costs. Under ASU 2016-14, the financial statement must include additional detail as to which types of expenses are allocated and explanation of the methodology utilized.

While some expenses can be allocated in their entirety to a single function through specific identification (direct allocation), most expenses relate to more than one function and need to be allocated among the functions benefited. Direct allocation of specific expenses is the preferable method of charging expenses to various functions. However, if specific identification is not practicable, an allocation is appropriate. The allocation methodology utilized should be reasonable, consistent, and periodically reviewed and challenged. Objective methods of allocating expenses are preferable to subjective methodsm and allocations may be based on related financial or non-financial data. Common allocation metrics include time and effort, direct costing, and usage of space (i.e. square footage).

How We Can Help
ASU 2016-14 is effective for annual financial statements issued for fiscal years beginning after December 15, 2017, and interim periods within fiscal years beginning after December 15, 2018. Citrin Cooperman’s Not-for-Profit Practice professionals can assist you in further understanding the impact of the changes that ASU 2016-14 will have to your Organization and its financial reporting.