FASB ASU 2016-14, Presentation of Financial Statements of Not-for-Profit Entities, is in full effect with the close of the December 31, 2018, fiscal year. As implementation progresses, a key provision of the new standard is likely to stir up the ongoing overhead debate. The standard’s requirement that audited financials present a statement of functional expenses by nature is a stark reminder to nonprofits that—regardless of their own positions and practices where it concerns overhead—accounting convention is once again putting the numbers that fuel the debate front and center.

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Fortunately, there is a way to both satisfy the new standard and go beyond it to present functional expenses in a manner more consistent with contemporary strategy and practice for nonprofit entities. This is an opportunity for CPAs to become advocates, helping nonprofits use the new standard to produce even more useful financial information for users.

How the Statement of Functional Expenses Fuels the Debate

At the center of the debate is the longstanding reliance on the overhead ratio (alternately known as the program efficiency ratio or the functional expense ratio) as a measure of nonprofit effectiveness and efficiency. This view values keeping overhead costs (i.e., the cost of core infrastructure) low. The assumption is that those nonprofits spending a higher percentage of their resources on what is broadly defined as overhead are less efficient than those that spend a lower percentage. Without a broader understanding of the financial strategies used by truly successful nonprofits, the presumption is that low overhead rates point to the best-run organizations.

What is concerning about the new FASB standard is that it refocuses attention on functional expenses. By requiring nonprofits to show functional expenses by nature (i.e., line item), there is an implicit assumption that the functional expense breakout is even more important. Focusing too narrowly on the statement of functional expenses could lead financial statement readers to misguided conclusions about whether a particular nonprofit is successfully carrying out its mission.

An Alternative Viewpoint Requires an Alternative Presentation

Fortunately, many nonprofit leaders and their supporters understand the importance of investing in and strengthening their core administrative, HR, IT, governance, and fundraising functions, and are rightly questioning the efficacy of the overhead ratio as a measure of organizational efficiency. Recent research out of North Carolina State University caught the attention of the Wall Street Journal for suggesting that, instead of providing a measure of nonprofit efficiency, the ratio actually correlates negatively to nonprofit financial and programmatic success (Jason Coupet and Jessica Berrett, “When It Comes to Evaluating Nonprofits, It Isn’t All About the Overhead,” Wall Street Journal, Dec. 16, 2018, https://on.wsj.com/2Y7lMW0). For years, many in the nonprofit sector, including the author, have advocated for an alternative view of overhead that encourages strong investment in core organizational needs rather than discourages it (Curtis Klotz, “A Graphic Re-visioning of Nonprofit Overhead,” Nonprofit Quarterly, Aug. 16, 2016, http://bit.ly/2FeaZ3x).

CPAs should do their part to help nonprofits navigate the new reporting requirement. The challenge is finding a way to display functional expenses while remaining true to nonprofit values where it concerns overhead. Using an alternative display is a powerful way to offer a different point of view.

Satisfying the Minimum Requirements

The guidance provided in ASU 2016-14 is meant to establish a minimum threshold of practice and presentation. But once that minimum is met, nonprofits have the opportunity to use their audited financials to more fully share their financial stories.

Exhibit 1 comes from ASU 2016-14 and is an example of a statement of functional expenses by nature. Showing expenses by nature translates into displaying those expenses by line items, which meets the minimum requirements of the standard.

Exhibit 1

Statement of Functional Expenses by Nature

Program Activities; Supporting Services A; B; C; Programs Subtotal; Management and General; Fundraising; Supporting Subtotal; Total Expenses Salaries and benefits; $7,400; $3,900; $1,725; $13,025; $1,130; $960; $2,090; $15,115 Grants to other organizations; 2,075; 750; 1,925; 4,750; –; –; –; 4,750 Supplies and travel; 890; 1,013; 499; 2,402; 213; 540; 753; 3,155 Services and professional fees; 160; 1,490; 600; 2,250; 200; 390; 590; 2,840 Office and occupancy; 1,160; 600; 450; 2,210; 218; 100; 318; 2,528 Depreciation; 1,440; 800; 570; 2,810; 250; 140; 390; 3,200 Interest; 171; 96; 68; 335; 27; 20; 47; 382 Total Expenses; $13,296; $8,649; $5,837; $27,782; $2,038; $2,150; $4,188; $31,970 The financial statements report certain categories of expenses that are attributable to more than one program or supporting function. Therefore, these expenses require allocation on a reasonable basis that is consistently applied. The expenses that are allocated include depreciation, interest, and office and occupancy, which are allocated on a square-footage basis, as well as salaries and benefits, which are allocated on the basis of estimates of time and effort. (ASU 2016-14, 958-205-55-21, Note F, page 66)

Telling a More Complete Story

No one ratio or financial statement can tell the full story of a nonprofit business model. FASB makes clear that its model disclosures and statement mock-ups are meant to provide guidance and should not be seen as the only proper way to display information.

These illustrations are intended as examples only; they present only a few of the permissible formats. Other formats or levels of detail may be appropriate for certain circumstances. … Not-for-profit entities (NFPs) are encouraged to provide information in ways that are most relevant and understandable to donors, creditors, and other external users of financial statements. (ASU 2016-14, 958-202-55-2, page 39)

Where it concerns the statement of functional expenses and the overhead debate, nonprofits can use this flexibility to tell a more sophisticated story.

One way to counter the overreliance on the functional expense ratio is to show that supporting services (e.g., management and general, fundraising) do indeed support the program activities and should not be seen as separate from, or diminishing of, program effectiveness. Of course, this requires that nonprofits actually allocate these expenses back to programs using an appropriate basis. For nonprofits that allocate administrative and fundraising costs to programs, the result is a more complete understanding of the true program costs or full costs of each program area. This is a powerful tool for measuring the actual program performance and is more in line with the reality of nonprofit business models.

Program work—that is, the mission—cannot get done without the benefit of and expense of core supporting services. Exhibit 2takes the sample ASU statement of functional expenses one step further by displaying the allocation of supporting services to program activities.

Exhibit 2

Statement of Functional Expenses by Nature with Supporting Services Allocated to Program Activities

Program Activities; Supporting Services A; B; C; Programs Subtotal; Management and General; Fundraising; Supporting Subtotal; Total Expenses Salaries and benefits; $7,400; $3,900; $1,725; $13,025; $1,130; $960; $2,090; $15,115 Grants to other organizations; 2,075; 750; 1,925; 4,750; –; –; –; 4,750 Supplies and travel; 890; 1,013; 499; 2,402; 213; 540; 753; 3,155 Services and professional fees; 160; 1,490; 600; 2,250; 200; 390; 590; 2,840 Office and occupancy; 1,160; 600; 450; 2,210; 218; 100; 318; 2,528 Depreciation; 1,440; 800; 570; 2,810; 250; 140; 390; 3,200 Interest; 171; 96; 68; 335; 27; 20; 47; 382 Total Expenses; $13,296; $8,649; $5,837; $27,782; $2,038 $2,150; $4,188; $31,970 Allocation of Management & General; 1,079; 568; 251; 1,898; (2,038); 140; (1,898); – Allocation of Fundrasing; 1,124; 633; 533; 2,290; – (2,290); (2,290); – Total Expenses after Allocation; $15,499; $9,850; $6,621; $31,970 –; –; –; $31,970 The financial statements report certain categories of expenses that are attributable to more than one program or supporting function. Therefore, these expenses require allocation on a reasonable basis that is consistently applied. The expenses that are allocated include depreciation, interest, and office and occupancy, which are allocated on a square-footage basis, as well as salaries and benefits, which are allocated on the basis of estimates of time and effort. In order to properly display the true costs for each program area of the organization, the financial statements display a proportionate allocation of supporting services expenses to each program area. The organization has chosen to allocate management and general expenses by full-time equivalent attributable to each program area.

CPAs as Advocates

Regardless of what one thinks of the overhead ratio and its usefulness, CPAs can advocate for nonprofit clients and employers to display their financial information in a way that counters overreliance on that single measure. For some nonprofits, this means boldly displaying the allocation methods they already use in the statement of functional expenses; others may first need to rethink and redesign their accounting systems to capture the data needed to accurately make these allocations. In either case, CPAs can help nonprofits move toward a more effective financial strategy that takes into account the true, full cost of program activities.

Curtis Klotz, CPA serves as director of nonprofit innovation at CLA (CliftonLarsonAllen), Minneapolis, Minn., and is primary author of the CLA Innovation in Nonprofit Finance blog.