Functional Expenses: Refresher and Tips for Not-for-Profits

Overview of FASB Requirements for Nonprofit Functional Expense Analysis

In August 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standard Update (ASU) 2016-14 –Presentation of Financial Statements of Not-For-Profit Entities (Topic 958). This ASU was effective for annual financial statements issued for fiscal years beginning after December 15, 2017. One of the major provisions of the ASU is that not-for-profit entities are now required to disclose expense amounts by both their natural classification and their functional classification. This functional expense analysis can be provided on the face of the statement of activities, as a separate statement of functional expenses, or in the notes to the financial statements.

Clarification of Nonprofit Natural Expenses vs Functional Expenses

Natural expense classifications are a grouping of expenses according to type. Examples include salaries and wages, rent, professional fees, and depreciation. Functional expense classifications are a grouping of expenses according to purpose. The most common functional expense classifications within not-for-profit financial statements are program activities and supporting services. Program activities are those expenses that directly support the mission of the organization. Supporting services, which cannot be directly linked to one program, are further broken out into fundraising costs and management and general expenses. Users of the financial statements generally prefer to see a not-for-profit organization with the largest allocation of expenses as program activities. While fundraising costs and management and general expenses are important to the operations of the organization, an efficient organization will be able to minimize these costs.

Allocating Natural Expenses Among Functional Expense Classifications

One natural expense type will often fall under multiple functional expense classifications. Management must determine proper methodologies for allocating natural expenses over various functional expenses. For example, salaries and wages may be allocated based on an estimate of time spent on each purpose and rent may be allocated based on the square-footage of the building used for each purpose. There are also certain costs that relate directly to one or more programs. For example, a marketing coordinator may be hired solely for assisting with fundraising efforts and their time would be designated 100% to fundraising expenses. The allocation methods used should be reasonable, consistent, and well documented. Topic 958 not only requires disclosure of expenses by natural and functional classification, but also requires disclosure of the allocation methods in the notes to the financial statements. The financial statement disclosures should include a suitable level of detail in order to provide meaningful information to the users of the financial statements, including donors, grantors, creditors, and organizational leaders.

6 Steps to Consider in Allocating Expenses Among Functional Classifications

Management should consider taking the following steps to assist in allocating expenses among functional classifications:

1. Review the chart of accounts for expenses and identify which expenses are directly linked to a single functional expense category. Evaluate the remaining expense types and brainstorm reasonable allocation methodologies.
2. Review the organization’s Form 990. Functional expense reporting is required on the tax return and can be used as a great tool for grouping expenses. There are differences in the reporting framework between the IRS and GAAP so these two statements will not always match up perfectly. For example, certain expenses may be recognized when incurred for GAAP purposes but will not be recognized until paid for tax purposes. Talk to your tax advisor for further detail.
3. Request that employees summarize actual time spent on different activities over a stated period of time and use this information as a basis for future expense allocations. For most not-for-profit entities, payroll and related costs are a significant portion of total expenses.  Meticulous timekeeping is critical if functional expenses will be allocated based on time spent.
4. Compile a listing of activities taking place within the physical space maintained by the organization by square footage and use this information as a basis for future occupancy expense allocations.
5. Once a functional expense allocation plan is approved, document it in writing. Share the plan with organizational leaders, auditors, and users of the financial statements.
6. Analytically review functional expense classifications each reporting period and compare amounts to prior periods. Make sure any significant variances make sense and can be explained to users.

Revisit the plan on a regular basis. While allocation methods should generally remain consistent year over year, any major changes to the organization should be analyzed for their effect on the allocation plan. Examples include new funding streams or debt, new programs, personnel changes, changes to staffing roles and responsibilities, changes to rental space, etc.

Questions on allocating expenses for your not-for-profit organization? Please reach out to your Keiter Opportunity Advisor or Email | Call: 804.747.0000. We are here to help.

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