Prior to 2017, many nonprofits gladly left the functional expense reporting to voluntary health and welfare organizations; those groups were the only ones required to do it at the time. But when the Financial Accounting Standards Board (FASB) issued the Accounting Standards Update (ASU) 2016-14, the requirements changed.
With this ASU, all nonprofits are now to report the relationship between functional expenses, such as program services and supporting services, and natural expenses, such as salaries, utilities and rent. Nonprofits must present the relationship between the two forms of expenses concurrently. They can do so in a financial report either at the beginning of the statement of activities, in the notes of the financial statements or as a separate financial statement.
For most nonprofits, we recommend the latter – creating a separate financial statement. Below are 5 best practices for your nonprofit when drafting this statement.
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.
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.
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