On a statement of functional expenses for a voluntary health and welfare organizations

By Nicole Loux, CPA

There have been many questions about implementing Accounting Standards Update 2016-14 Preparation of Financial Statement of Not-for-Profit Entities (ASU 2016-14). One question that has come up is the new requirement for functional expenses. Under old guidance only voluntary health and welfare organizations were require to provide information on their functional expenses. Now, all not-for-profit entities are required to provide information about their operating expenses.

ASU 2016-14 requires a not-for-profit entity to report information about expenses in one location, either on the face of the statement of activities, as a separate statement (statement of functional expenses) or in the notes to the financial statements. ASU 2016-14 also requires enhanced disclosures about the methods used to allocate cost among activities and to disaggregate their expenses by nature and by major class services.

What does that exactly mean? It means not-for-profits are required to break down expenses by their type, such as salaries and benefits, utilities, insurance, depreciation, etc. and by major class, program, fundraising and/or management and general. Some of the natural classes of expenses will be driven 100% by either program activities, fundraising activities and/or management and general activities. Other expenses, such as salaries and depreciation expense, will need to be allocated to the various activities. Here are some examples of how the expense can be allocated.

Depreciation Expense:

Depreciation expense could be allocated to the various activities by determining what portion of the building is used for each activity. A way to determine what portion of the building is used by each activity is to determine what space each activity uses and allocate it based on square feet. Another way depreciation expense can be allocated is if there is specific equipment that is used only for one activity, the depreciation for that equipment can be 100% allocated to that specific program.

Salaries:

In salary expense, most likely there will be individuals who are 100% dedicated to one type of activity and then have several individuals who are dedicated to several different activities. To allocate the salary of individuals who work on different activities, estimate the percentage of time the individual spends on the different activities. If a time recording system is used, those records could be reviewed to determine what percentage should be allocated to each activity. Time studies could also be performed for a period to time to determine the allocation. If neither of those options are available, management should work with the employee to develop an estimate of time they spend on the different activities.

The important thing to remember is that these allocations are managements estimates and that means they do not need to be 100% accurate. Remember to document how you came up with your allocations as that information will be used to develop the enhanced footnote disclosure that is required under ASU 2016-14.

ASU 2016-14 requires that the changes be applied on a retrospective basis in the year of adoption, however, if presenting comparative financial statements, the not-for-profit has the option to omit the functional expense information for any periods presented before the period of application. Which means in the year ASU 2016-14 is adopted you only need to determine and disclose the functional expense information for that year (example you adopt ASU 2016-14 for the year-ended December 31, 2018 you are only required to report on functional expenses for 2018). You will need to disclose that you elected not to present the prior year information as allowed under ASU 2016-14.

ASU 2016-14 is effective for annual financial statements issued for fiscal years beginning after December 15, 2017 (calendar year 2018 and fiscal year 2019).

Please feel free to contact us if you have any questions, thoughts, or comments.

Nicole Loux, CPA | Manager

1 – Know Your Organization’s Allocation Methodology

Allocation is key to this ASU update. Organizations must classify – or allocate – both functional expenses, those costs incurred to run the services and programs essential to the nonprofit’s mission, and natural expenses, those costs required to keep any business running (employee salaries, rent, etc.).

Being aware of your organization’s methodologies, or even defining them if your nonprofit has no set procedures, is a must. Considering the user – the one reading the financial statement – is essential when determining your organizations’ methodologies. For example, using time sheets may be the right choice when reporting salaries, but an estimation of employee time along with a note explaining why this methodology was chosen may be sufficient too.

Understanding how the reader intends to use your nonprofit’s financial statement and then using methodologies to match that purpose will help reporting to go smoother.

2 – Allocate for 5-10 Natural Expenses

 A common mistake we see is a nonprofit reporting too many natural expenses. There are no guidelines for the number of natural expenses to report. Therefore, we usually suggest using 5-10 categories.

Once again, remember the user who this financial statement is intended for. Too many natural expenses lead to confusion, actually muddying their understanding rather than clarifying your organization’s financial standing.

3 – Understand the Full Breadth of Your Employees’ Work

When ASU 2016-14 was first issued, many were frustrated. Nonprofits are now to allocate human resources and accounting under general/management expenses (a category of functional expenses). Many worried that watchdog groups would report a larger percentage of a nonprofit’s funds going towards management rather than towards the nonprofit’s mission.

With the competition high for charitable giving, we understand this frustration with the update (and even the concern over watchdog groups construing information).

However, fully understanding everything an employee does for your organization helps when creating a financial statement. For example, if your human resources team assists with program planning throughout the year, a percentage of their salaries may be allocated under program expenses and not under general/management.

We suggest holding discussions with your employees so you understand all of the ways they help the organization. This discussion then helps determine your allocation methodology.

4 – Be Careful When Disaggregating Your Organization’s Program(s)

Yes, disaggregation is important for creating transparency in financial reports. (Transparency was the goal in issuing ASU 2016-14.) But, be wary.

Disaggregating your organization’s program(s) too much, and the information becomes granular – nearly useless to the reader.

Remember, your goal with a financial statement is to make it informative to the reader – to the donor, the auditor, the agency, the board. Therefore, we suggest caution when breaking down the parts of your program(s). A user should be able to understand more clearly (not less clearly) your group’s mission by reviewing your financial statement.

5 – Remember Membership Development Costs 

Often, nonprofits forget about allocating for membership development. And it can be take a significant amount of money and employee time. Most likely, these costs fall under supporting services, which is a functional expense. As an organization, you will need to consider your allocation methodology for reporting these expenses.

Conclusion

We’re experts at nonprofit accounting. That means, we can help with allocation methodology. And we’d love to create financial statements for your organization to help the reader understand the good work you do and how you spend your hard-earned funds.

Complete the form below to start a conversation.

Why is the Statement of functional expenses required for voluntary health and welfare organizations?

What is a Statement of functional expense?

Which one of the following statements is not required for voluntary health and welfare organizations?

Which of the following is required to prepare a Statement of functional expenses?