Lessons Learned from Implementing ASU 2016-14 – Functional Expenses

Accounting Standards Update (ASU) 2016-14, Not-for-Profit Entities (Topic 958): Presentation of Financial Statements of Not-for-Profit Entities marked a significant change in the way nonprofits report on their finances. The ASU is effective for annual financial statements issued for fiscal years beginning after Dec. 15, 2017, thus nonprofits with calendar year ends are currently working to implement the provisions. 

As organizations have undertaken implementation efforts, we have seen one area is causing more issues than anticipated—the presentation of the analysis of expenses by function and natural classifications. As part of preparing this information, entities are examining their current cost allocation methodology, as well as what components—both program and natural expense classifications—they want to include.

Overall, the organization can decide whether to present this information in the statement of activities, as a separate statement of functional expenses that is part of the main financial statements, or as a footnote. But one problem persists: Which presentation method will be most efficient, and which will be most beneficial?

Our advice on the presentation? Keep it simple. Yes, the analysis of expenses by function and nature should show the natural expenses of the entity by program and supporting activities, but this doesn’t mean that every type of expense should be presented on its own line. A straightforward approach will prevent the presentation from becoming overly complex and unwieldy. Keep the end audience in mind: Focus on the information that will be useful to the reader of the financial statements in understanding the costs of the activities of the entity. Decide on which natural classification groupings are important and relevant. Keep in mind that too much detail can overwhelm the reader of the financial statements.

Once the format is determined, entities should look at their allocation methods for their management and general costs (M&G) and determine if the items being allocated are necessary for the direct conduct or supervision of programs and supporting activities, such as membership development or fundraising. If not, the items shouldn’t be allocated. The costs that are allocated should only be for the direct benefit of the activity they are being allocated to. For example, occupancy costs can be allocated to programs if the programs utilize space to conduct their activities. In this case, the cost of the space is related to the direct conduct of the program and should be allocated to this functional classification to show the direct benefit the program receives from the use of the space.

Another example provided in the ASU addresses the consideration of the Chief Executive Officer’s (CEO) compensation. An organization may have all of the CEO’s salary recorded as M&G. But upon further examination, they may determine that the CEO is directly involved in supervising one or more programs of the entity. In addition, an organization may find that the CEO is directly involved with current and potential donors on fundraising cultivation activities. If this is the case, a portion of the CEO’s compensation and benefits could be allocated to the program and fundraising functions based on the portion of time spent on these activities as they reflect direct conduct or direct supervision. The costs for the CEO’s time to oversee the general operations of the entity, however, would remain in M&G.

The ASU changed the examples of what constitutes management and general activities, adding employee benefits management and oversight (human resources) to the list. Entities should look at their internal policies to determine how these costs have been traditionally treated and, if allocated, modify and adjust prior year numbers for the financial statements to remain comparable.

It is important to note that all expenses, with the exception of external and direct internal investment expenses, should be reported by their natural classification in the analysis of expenses by nature and function. An example of a scenario that is often excluded, but shouldn’t be, is any salaries or other expenses included in cost of goods sold that are presented net of the related revenue in the statement of activities.

Once these allocations are reviewed by the entity, it should update its policies and develop the new required footnote disclosure that provides a description of the methods used to allocate costs among program and support functions.
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