By Jayme F. Moore, CPA
Vice President & Director
Under Accounting Standards Update (ASU) 2016-14, Not-for-Profit Entities (Topic 958): Presentation of Financial Statements of Not-for-Profit Entities, nonprofit organizations are required to present the relationship between functional expenses and natural expenses on the financial statements. Disclosure is also required within the footnotes regarding the methods used to allocate costs among programs and supporting functions. For many nonprofits, a separate statement of functional expenses is the most effective manner to present the analysis. 
For nonprofits, the statement of functional expenses is a meaningful, yet often overlooked, statement within the financial statements that provides crucial information to the reader. The statement of functional expenses connects the dots between revenue and mission execution by clearly showing how an organization spends its money. That’s important information for both management and donors.
Nonprofits should be evaluating allocation and methodology for allocation every year, ensuring that the reflection of where the organization’s dollars were spent, particularly for program expenses, tells the nonprofit’s story and the execution and achievement toward its mission.
Why is the statement of functional expenses crucial to the financial statement reader?
The statement of functional expenses is an invaluable tool for decision-making. It allows the reader to clearly see what each program costs, whether fundraising is proportionate and appropriate, and whether a specific program is sustainable. Many costs are directly related to a specific program, but other costs are not and therefore must be allocated. When allocating expenses, management should apply reasonable, consistent methods so information is presented in a way that facilitates comparison. However, this doesn’t mean allocations can’t be changed, and the allocations should, in fact, be evaluated on an ongoing basis. The allocations are management’s best estimates, and the methods of allocation may vary based on the types of expenses. For example, occupancy related costs are allocated by square footage of space occupied by each program and supporting service, while other allocations are made based on other factors.
Why is it important to evaluate expense allocations on a regular basis?
Many organizations rely on outside gifts and grants, and donors may rely on financial factors and ratios in making decisions about where to spread their philanthropy. Such decisions may be based on the functional expense reporting, particularly the total program costs in relation to the overall costs, as well as the amount of fundraising costs compared to total contributions. There are many key ratios a donor may rely on, and they can be impacted when expense allocations are not done properly and accurately.
Why are financial ratios important?
While certain financial ratios may be useful to potential donors, they are just as important internally. Ratios can reveal key information about the organization’s performance, trends and overall health and sustainability of programs. Evaluating this financial information should be a significant part of managing and monitoring the organization as well as planning for the future. Financial ratios are also a great tool to benchmark against peers when the information is comparable and available – key words being “comparable and available.”
Every organization is unique and not every ratio will make sense for all. When benchmarking against peers, organizations should ensure that the peers included in the analysis are of similar size and age, are in similar geographic locations, and have similar missions or programs. Whether or not your organization performs peer benchmarking analysis, you should be evaluating key ratios that make sense for your organization on a regular basis, essentially benchmarking against your own historical data. Evaluating trends over time is an essential tool for good decision making, as it highlights organizational strengths and weaknesses.
If you would like to discuss functional expenses and how the key ratios you measure can help reveal insights into your organization’s financial health, please contact your G.T. Reilly advisor.
