Nonprofit Functional Expense Allocation Under ASC 958-720 and ASU 2016-14: Methods and Audit Testing

Donors, grantors and regulators read one ratio closely: how much of each dollar went to programs. That ratio comes from the functional expense allocation, and since ASU 2016-14 every nonprofit presents it. This post covers the presentation requirement, how allocations are built, the methodology disclosure, and how an auditor tests the result.

For the full financial statement set, see nonprofit financial statements under ASC 958. For revenue-side guidance, see contributions and grants under ASC 958-605. The grant-funded programs those grants fund are reviewed separately in the single audit walk-through.

What ASU 2016-14 requires

Before ASU 2016-14, only voluntary health and welfare organizations had to present an analysis of expenses by function and nature. The ASU extended the requirement to all not-for-profit entities. It is effective for fiscal years beginning after December 15, 2017, and for interim periods within fiscal years beginning after December 15, 2018, and it applies retrospectively.

The requirements:

• Both classifications. Expenses are reported by function (program services and supporting activities) and by natural classification (salaries, occupancy, professional fees and so on).
• One location. If the statement of activities does not show both, the two classifications appear together in one place: a separate statement of functional expenses, or a note. The matrix format, with natural expense lines as rows and functions as columns, is an appropriate presentation.
• Reconciliation. Expenses that the statement of activities does not report by nature, such as cost of goods sold, are broken out by nature in the analysis. The analysis reconciles to the statement of activities.
• Investment expenses. Investment return is reported net of external and direct internal investment expenses, and those netted expenses are outside the functional analysis. This applies to total return investing, not programmatic investing. Direct internal investment expenses are those tied to conducting and supervising investment activities.

Functional classes are program services and supporting activities. Supporting activities are management and general, fundraising and, where it applies, membership development. Management and general covers oversight, business management and general administration of the entity, which includes employee benefits management and human resources oversight.

What gets allocated and what does not

The test for allocation is direct benefit. Costs are allocated only for the direct conduct or supervision of programs or supporting activities, and a cost that benefits one function is charged to that function directly with no allocation needed.

Common allocation cases:

• Occupancy. Rent, utilities and maintenance move to functions on the space each function uses.
• Executive compensation. A CEO's pay is split on time spent directly supervising programs or on fundraising cultivation. Time spent on general oversight stays in management and general.
• Shared staff. Finance, HR and IT salaries follow time records for the functions served. Oversight and general administration of the entity itself remain in management and general.
• Cost of goods sold. Salaries and other costs inside cost of goods sold, which the statement of activities nets against revenue, are easy to miss. They still appear in the natural classification analysis.

Allocation bases

Pick the base that matches how the cost is incurred, and keep it consistent year over year:

A budget percentage with no link to actual activity is the weakest base. Review each percentage every year against actual operations.

The methodology disclosure

ASU 2016-14 requires disclosure of the methods used to allocate costs among program and support functions. A usable disclosure names:

• The categories of expense that are allocated.
• The base for each category.
• The functions that receive the allocation.

Example wording: "Salaries and benefits are allocated on the basis of time and effort. Occupancy and depreciation are allocated on square footage. Costs not allocated are charged directly to the program or supporting function that incurred them." The disclosure must match what the schedule actually does. An allocation note that cites square footage while the workbook uses a fixed percentage is a finding.

How auditors test functional allocation

Functional expense is a presentation and disclosure assertion, and it carries audit risk because donor and grantor decisions rest on the ratios. The audit procedures:

1. Obtain the allocation workbook and tie total expenses by function to the statement of activities and the trial balance. Foot and cross-foot the matrix.
2. Test the bases. Re-perform one allocation per base: recompute square footage shares, agree timesheet percentages to signed time records, and agree payroll data to payroll reports.
3. Compare with prior year and with the budget. Investigate shifts in the program ratio. A move of several points needs an operating explanation, such as a closed program or a new fundraising campaign.
4. Read for consistency. Compare the allocation policy in the note, the board-approved policy and the workbook.
5. Test the supporting activity lines. Confirm that fundraising costs include the activities that solicit funds, and that management and general holds oversight and administration. Direct charges to program from grant accounting should trace to the grant ledger.
6. Cross-check against other disclosures. The program expense ratio in the management discussion and in grant reports should agree with the audited ratio, or the difference is explained.
7. Evaluate misstatement. Misallocation between functions does not change total expenses or net assets, but it changes the ratio users rely on. Evaluate it qualitatively as well as quantitatively. The materiality guide covers the approach.

Where the work breaks

• Occupancy allocated 100 percent to management and general after a program moved into the space.
• Salary percentages set at hire and never refreshed.
• Grant reimbursements that use a different allocation than the audited financial statements. The pairing between the two is worth a tick mark.
• A new fundraising event whose costs sit in program services.
• Natural classification totals in the matrix that do not agree with the statement of activities because cost of goods sold was left out.

When the general ledger tracks class or location by function, the workbook starts from the ledger by class and only the shared costs need a base. Where classes are missing, the first reconstruction step is to map accounts to functions and document the mapping.

Sources

• Understanding the New Reporting Requirements for Not-for-Profit Entities, Withum
• Lessons Learned from Implementing ASU 2016-14: Functional Expenses, BDO

CORAA prepares ready-to-review audit files for US CPA firms from client accounting records; the firm keeps the client relationship, the review and the signature. See /us.

AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error