Functional Expense Changes Under FASB ASU 2016-14

Nonprofits with years ending December 31, 2018, and later will implement the new nonprofit accounting standard, FASB ASU 2016-14, Presentation of Financial Statements of Non-Profit Entities. This new standard is the first significant change to nonprofit accounting in 20 years. One of the key changes in this standard relates to functional expenses.

Under the current standards, voluntary health and welfare organizations must present a statement of functional expenses that breaks down, in a grid format, natural and functional expense classifications. Also, all nonprofits must report their expenses on a functional basis, which can be done on the face of the statement of activities, in a statement of functional expenses, or in a footnote to the financials. Under the new standard, all nonprofits will be required to provide an analysis of expenses by their nature and function.

For voluntary health and welfare organizations, this will look very similar to the current statement of functional expenses, as a statement is one manner in which the information can be provided. For other organizations, this will be a brand new statement or extensive footnote; we recommend a statement for most organizations. Theoretically, those other organizations should have already had a supporting schedule in their work papers to their financial statements showing how they got from the natural expenses to the functional classifications, but many organizations may have simply taken a percentage estimate in total.

Start planning now

If your organization has not previously done a statement of functional expenses, you need to start planning now for how you will obtain the information to be able to create, essentially, a statement of functional expenses. Consider if this is something that should be done via direct allocation as expenses are recorded, and thus may necessitate a change in your chart of accounts structure, or if it is best done using an indirect allocation during the financial statement preparation process. Either way, changes to the internal control structure may be necessary to track the information to properly allocate these expenses in a grid showing natural and functional expenses.

Investment expenses

However, even for those who previously did a statement of functional expenses, there are a few changes. Previously GAAP allowed the netting of investment expense with investment return. Some organizations did this and others did not. Most of the time those expenses were direct expenditures to third parties for investment fees and management. This new standard removes the option, and external investment expenses, as well as direct internal investment expenses, must be netted with investment income.

Organizations may not have procedures in place to track the direct internal investment expenses or to allocate them using an indirect allocation. These expenses include the direct conduct or direct supervision of the strategic and tactical activities involved in generating investment return. For example, if your executive director is involved in the due diligence process for changing investment firms – or if your investment firm provides quarterly meetings that your Controller attends to learn about the investment strategies and options – the time for those is an investment expense that must be netted against investment revenue. Most entities have just considered that internal investment expense to be management and general.

Do be aware, for entities like community foundations, where investing is part of the programmatic achievements, their accounting will not change and their investment income, because it is programmatic, will remain gross. This will involve changes in internal controls over time tracking and possibly expense documentation. It may also involve a change to the chart of accounts to allow those expenses to be broken out in the trial balance.

Other changes

Traditionally certain things may have been excluded or included in the statement of functional expenses that will need to change under the new standard.

• Gains and losses are specifically excluded from this analysis of expenses by nature and function; by definition they are not expenses.
• Certain special event expenses, if the special event is not major and ongoing, have traditionally been netted against revenues. Although they can continue to be netted against revenues, they will also need to appear in this analysis of expenses by nature and function. Also, they have to be included based on the nature of the expense. For example, if you have a gala event that meets the requirements that the special event expenses can be netted against revenues, under the new standard those expenses will need to be in the analysis of expenses by nature and function, and they will go to line items like salaries, entertainment, rent, food, and not to a single line item like gala event.
• Cost of goods sold also has to be broken out by nature, and not just lumped together as one line. This is another area that likely will require either an expansion of the chart of accounts or more detailed recordkeeping.

Management and general expenses vs. program expenses

FASB also strengthened the example of what is management and general versus what is program. Program expenses include the direct conduct or direct supervision of programmatic purposes; they do not include general overall supervision. For example, the program department director reports to the executive director and keeps the executive director in the know about programs; this is not direct conduct or direct supervision on the executive director’s part. However, the program department director is out on medical leave and during that time the executive director is giving directions and following up to specifically manage the staff in the program department to ensure the program is being accomplished; this is direct supervision and would be allocable to program expenses.

The standard calls out financial reporting for grants as being specifically management and general, too. Although we do not believe the intent of the standard has changed, many organizations had different interpretations of the original standard and will see additional management and general expenses under the new standard.

Organizations should start discussing these changes with management, the board, and funding sources to prepare them for changes in the program service expense percentages.