Armanino Blog

FASB Update Part 2: Accounting for the Money

by Stacie Kowalczyk
December 16, 2016

Part 2: Functional expense allocation

The recently released Accounting Standards Update, Presentation of Financial Statements of Not-for-Profit Entities, represents a conceptually different approach to how information is presented in nonprofit financial statements.

Those who prepare the financial reporting for your organization will certainly be impacted. Yet, the hope is that these changes will also enable you to better tell your financial story.

To help nonprofits prepare, Armanino has prepared a deep dive into the new standards, including guidance on implementation. We continue this series with a look at changes to how your organization classifies its expenses.

Functional Expenses
To a degree, nonprofits already group expenses according to the purpose for which they are incurred. These functional expense classifications appear on your IRS Form 990 and break expenditures into both program services and supporting activities.

Under the new accounting standards, you’ll also need to include this information in your financial statements. Specifically, expenses must be reported by both their nature (salaries, rent, transportation) and function (program services, management, fundraising). Up until now, this type of expense analysis was required only of voluntary health and welfare entities.

The presentation of expenses must be provided in a single location, but nonprofits do have a choice in how to present this information, including:

  • on your Statement of Activities,
  • as a separate statement, or
  • within notes to the financial statement.

You’ll also need to provide additional disclosures outlining the specific methods you use to allocate costs among program and support functions. 

Here’s how expense allocation under the new standards might look for a nonprofit university:

Be Aware of the Issues
As you think through the impact of the updated accounting standards, you’ll also need to be aware of these additional issues related to expense reporting:

Enhanced disclosures — You’ll need to supplement your analysis of expenses with enhanced disclosures about the methods used to allocate costs among program and support functions.

Investment expenses — You will now be required to net investment expenses against the investment return you present on your statement of activities. This includes external as well as direct internal expenses. For example, compensation costs for employees who spend part of their time managing investments would not appear in the functional expense analysis if they are offset against investment income.

Under the new standard, you will no longer disclose the components of those netted expenses. This removes the challenge that some nonprofits faced in identifying management fees that were embedded in investment returns.

501(c)(6) organizations — Business leagues, chambers of commerce and other trade groups have not been required to present expense allocation information in the past, but will now be required to do so under the new accounting standards, with member services as one of the functional categories.

Costs — Certainly, there will be some initial costs to comply with the new standards, but ongoing compliance costs after implementation are expected to be fairly minor. Costs may include those related to gathering additional data, making changes to your financial reporting processes, and communicating the changes to financial statement users.

Our Recommendations
As you consider how these accounting changes will impact your financial reporting, we offer these general recommendations:

  1. Decide on a format. The American Institute of CPAs notes that while a separate statement of functional expenses is not required, it may be the most effective presentation option for nonprofits with more than one program. The key is for expenses to be presented in such a way that the relationship between the function and nature of the expense is evident. Note that the current matrix presentation used for most statements of functional expenses is an appropriate format to use.
  2. Review your systems. Make sure your current accounting system is set up to produce expenses by their natural classification within the functional classifications.
  3. Revisit your processes. Take a look at how you are allocating expenses to ensure that they are being spread correctly across the appropriate functions.
  4. Identify investment expenses. Make sure you can segregate out internal investment expenses (e.g., an internal investment manager’s salary) so they can be netted against investment income.
  5. Keep it simple. Keep aggregation of natural categories as simple as possible while meeting the needs of management and third parties. 

Moving Forward
Implementation of the new accounting standards is effective for fiscal timelines beginning after December 15, 2017. For most of our clients, that will be either the Dec. 31, 2018, calendar year or the fiscal year ending June 30, 2019.

Note that you have the option of presenting the analysis of functional and natural classification in the year of adoption, but are not required to present analysis for the comparative year presented.

Early adoption of the new accounting standards is certainly an option. Just be aware that you’ll have to adopt every aspect. As an interim step, consider preparing pro forma financial statements following the new rules to see how they will affect your organization’s financial reporting.

Ultimately, these changes to expense reporting are designed to help donors, grantors and creditors more easily understand the degree to which your nonprofit’s expenses are fixed or discretionary, how the related resources are being allocated and the true costs of the services provided.

As you begin preparing for these major changes, contact your local Armanino nonprofit expert for answers.

December 16, 2016

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