Center for Plain English Accounting AICPA s National A&A Resource Center available exclusively to PCPS members

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1 Report September 20, 2017 Center for Plain English Accounting AICPA s National A&A Resource Center available exclusively to PCPS members ASU Focusing on Functional Expense Allocations By: Mike Austin On August 18, 2016, the FASB issued Accounting Standards Update (ASU) , Not-for-Profit Entities (Topic 958): Presentation of Financial Statements of Not-for-Profit Entities. The amendments in this ASU are intended to improve financial statement presentation by not-for-profit (NFP) organizations a model that has existed for more than 20 years. The new guidance will affect substantially all NFPs, including charities, foundations, private colleges and universities, nongovernmental health care providers, cultural institutions, religious organizations, and trade associations, among others, and requires NFPs to improve their presentation and disclosures to provide more relevant information about their resources (and the changes in those resources) to their donors, grantors, creditors, and other users. There are qualitative and quantitative requirements in a number of areas, including net asset classes, investment return, expenses, liquidity and availability of resources, and presentation of operating cash flows. Practitioners and their NFP clients will need to be especially mindful of the enhanced and additional disclosures required by this ASU. The changes included in this ASU present an opportunity for NFP organizations to reevaluate how they perform a variety of tasks and functions, which should include how expenses are presented and allocated on their financial statements. This report will explore the changes to expenses in greater depth than our previous report on ASU , which can be found here. Why Focus on Expense Allocations & Disclosures? While many users rightly focus on items included on the face of financial statements, cash on hand, net assets, total contributions, and cash flows from operations, expense allocations can draw considerable scrutiny for NFP organizations. A recent notable

2 example is found in a letter from Senator Chuck Grassley to the members of the Senate Judiciary and Finance Committees, in which he included the following excerpt regarding his inquiry into the operations and financial results of the Wounded Warrior Project (WWP): The WWP has repeatedly reported that it spent 80.6 percent of its donations on program services for veterans. After reviewing WWP s IRS Form 990 and Consolidated Financial Statements, it became apparent that this percentage was inaccurately inflated by inappropriately categorizing certain services. For example, WWP s 80.6 percent assertion includes tens of millions of dollars per year in donated media, such as free advertisements on television. These expenses are more appropriately categorized as fundraising solicitations for the organization. However, by including donated media in program expenses, WWP inaccurately reports that it spends a greater percentage of donor funds on program expenses that directly benefit veterans. These inaccuracies add up to serious overstatements about WWP s commitment to supporting veterans and understates the actual amount of money that WWP spends on program activities in pursuit of its mission. Senator Grassley s inquiry was prompted by reports from both CBS News and the New York Times that there were troubling conditions with the organization related to reports of exorbitant spending, which does not correspond to what was being reported in the financial statements. No organization, or their auditors, want to be in the position of either defending or explaining themselves to press or Congressional inquiries. As the appropriate allocation of many types of costs can include elements of significant judgement, the implementation of ASU can be used for improving long standing processes, both for your clients and in how assurance procedures are executed. Disclosure of Expenses by Function & Nature Under current U.S. generally accepted accounting principles, (U.S.) GAAP, the majority of NFP organizations only are required to present expenses by function. Functional expenses are typically classified in two categories: Program services: Activities that result in a good or service being distributed to beneficiaries, customers, or members that fulfill the purposes or mission for which a nonprofit exists Supporting Services: Activities other than program services, which can include o Management and General (M&G): Activities related to oversight o Fundraising: Activities to entice potential donors to contribute o Membership Development: Activities to gain or retain members

3 Currently only voluntary health and welfare entities are required to present expenses by their natural classification- salaries, rent, depreciation, etc. In order to make information about expenses more comparable and useful, the new standard requires all NFPs to provide information about their operating expenses by both nature and function on the face of the statement of activities, as a separate statement, or in the notes to the financial statements, supplemented with enhanced disclosures about the methods used to allocate costs among functions. Practice Note: While voluntary health and welfare entities were already required to present expenses by function and nature, adoption of the new guidance also will provide those types of organizations flexibility in how to present the information, opposed to being required to disclose the information as a separate statement. In addition, the removal of the definition of voluntary health and welfare entity from the master glossary removes the need to determine if an organization qualifies as one and, therefore, would be required to apply the legacy U.S. GAAP related to expense disclosure. As there is no standard prescribed format of how expense information should be presented in the financial statements, organizations are free to use any approach which satisfies the criteria in the ASU. Many organizations may find presenting the required information in the matrix format, currently used by voluntary health and welfare entities, to be most useful. CPEA Observation: Organizations which were not previously required to include disclosure related to expense by both function and nature may have elected to provide that information in a supplemental schedule. Once ASU is adopted, presentation of that information as a supplemental schedule will no longer be appropriate as it will become a required disclosure in the basic financial statements. Illustrative example of presentation using the matrix format Program Services Supporting Activities Community Disaster Total Managment & Total Total Services Services Programming General Fundraising Supporting Expense Salaries, benefits, and taxes $ 23,409 $ 84,202 $ 107,611 $ 48,736 $ 80,923 $ 129,659 $ 237,270 Supplies and travel 1,184 43,102 44,286 2,288 4,326 6,614 50,900 Services and professional fee 8, , ,847 60,990 49, , ,634 Rent 2,492 1,342 3,834 56,092 23,403 79,495 83,329 Deprciation 1,339 36,024 37,363 5,240 5,692 10,932 48,295 Total expenses $ 37,179 $ 409,762 $ 446,941 $ 173,346 $ 164,141 $ 337,487 $ 784,428 Illustrative example of presentation on the face of the financial statements (partial):

4 Expenses Managment & General Salaries, benefits, and tax $ 48,736 Supplies and travel 2,288 Services and professional 60,990 Rent 56,092 Deprciation 5,240 $ 173,346 Fundraising Salaries, benefits, and tax $ 80,923 Supplies and travel 4,326 Services and professional 49,797 Rent 23,403 Deprciation 5,692 $ 164,141 Total Supporting Expense $ 337,487 Clarified Guidance Related to M&G Expenses In order to increase comparability of financial statements between organizations, the definition of M&G included in the glossary was amended in order to address another area of diversity in practice. The current definition in the FASB ASC Glossary of M&G is as follows: Activities that are not identifiable with a single program, fundraising activity, or membership-development activity but that are indispensable to the conduct of those activities and to an entity's existence. The definition was amended to define M&G as: Supporting activities that are not directly identifiable with one or more program, fundraising, or membership-development activities. Under the current definition, an organization could take the approach that expenses such as information technology costs or the Chief Executive Officer s salary were not identifiable with a single program so, therefore, would just be included in M&G. The modified definition does not require costs to be identifiable to a single program in order to be included with the expenses, increasing the types of costs which could be allocated among multiple activities. For avoidance of doubt on the intent of the amended definition, the following guidance was added in FASB ASC A: Activities that represent direct conduct or direct supervision of program or other supporting activities require allocation from management and general activities.

5 Additionally, certain costs benefit more than one function and, therefore, shall be allocated. Application of this guidance would result in expenses such as information technology costs being allocated among the various functions that receive those benefits, as could potentially the salary expense of executives such as the CEO and CFO depending upon their responsibilities. The guidance also provides clarification in Case C (FASB ASC ) for items which would not be allocated from M&G, such as human resource (HR) functions, as benefits administration and payroll processing are a supporting activity for the entire entity. CPEA Observation: While the implementation provides examples that may be broadly applicable, individual facts and circumstances at organizations should always be considered. For example, while the implementation guidance indicates that HR functions would support the entire entity, consider a situation in which an organization spent a significant amount of time and money trying to fill a key programming position, potentially even engaging a pricey third-party search firm to find a highly-qualified candidate. In that situation, an argument could be made for direct costs being allocated to programming activities. Expense Allocation Disclosures As indicated above, NFP organizations will still be required to allocate costs which are attributable to more than one program or supporting activity, with an increased scope of the type of costs which would be eligible. The related disclosures also have been expanded to respond to concerns of stakeholders that the lack of specific guidance on cost allocations created the dreaded diversity in practice in functional expense ratios. As outlined in the first section of this report, those ratios can come under scrutiny from users of the financial statements. To respond to that concern the FASB included guidance that requires a qualitative description of the methods used to allocate expense attributable to more than one activity. Practice Note: No changes were made to the existing accounting or disclosure requirements for joint costs and they still should be evaluated on the purpose, audience, and content criterions. However, the required disclosures were expanded by the expense allocation disclosures to also require a description of the methods used to allocate joint costs. While the contents of this disclosure are not specified, an illustrative example is included in the implementation guidance: Note X. Methods Used for Allocation of Expenses from Management and General Activities

6 The financial statements report certain categories of expenses that are attributable to one or more program or supporting functions of the Organization. Those expenses include depreciation and amortization, the president s office, communications department, and information technology department. Depreciation is allocated based on square footage, the president s office is allocated based on estimates of time and effort, certain costs of the communications department are allocated based on estimates of time and effort, and the information technology department is allocated based on estimates of time and costs of specific technology utilized. In addition, the AICPA produced a similar disclosure in the illustrative financial statements for the fictional NFP organization Save Our Charities: The financial statements report certain categories of expenses that are attributed to more than one program or supporting function. Therefore, expenses require allocation on a reasonable basis that is consistently applied. The expenses that are allocated include occupancy, depreciation, and amortization, which are allocated on a square footage basis, as well as salaries and wages, benefits, payroll taxes, professional services, office expenses, information technology, interest, insurance, and other, which are allocated on the basis of estimates of time and effort. The standard does not require that every natural class of expense presented on the statement of functional expense be explained in the notes to the financial statements. As a result, judgment will be required in choosing which expense categories to explain. That determination will likely vary by entity and depend on both qualitative and quantitative factors. CPEA Observation: As the disclosures provided in both the illustrative guidance and the AICPA example financial statements are fairly vanilla in nature and, therefore, potentially applicable to many organizations, many NFP organizations may be tempted to copy and paste them into their financial statements without carefully reading them to ensure that the allocation methods described actually match what they are doing. Practitioners should exercise appropriate professional skepticism when clients use identical disclosures to those included above to ensure doing so is appropriate. Several aspects of cost allocation are based on estimates made by management and should be treated accordingly by practitioners. Practitioners will need to evaluate many considerations related to this estimate, including: If management has appropriately identified all costs which should potentially be allocated, and conversely, if management is attempting to allocate costs from M&G to other areas in order to make it appear as if M&G is lower than it should be. While

7 the new standard provided guidance to clarify that activities which represent direct conduct or direct supervision may be allocated, it s important to remember that other areas that previously may have been allocated such as human resources and payroll functions are now clarified to be M&G activities that should not be allocated. If the method used to allocate the costs is appropriate. For example, if the organization makes allocations of key employee salary based on time spent on an activity, how is that percentage determined? If a time recording system is used, those records could be reviewed; however, in most cases, the allocation is an estimate that is not supported by time cards or time allocation study, making it more challenging for practitioners to perform appropriate procedures. If management s process for estimating time and effort is capable of producing reasonable results. While some organizations have well documented policies and procedures for allocating estimates, others take a ceiling tile approach where management looks upward and comes up with the allocation percentages when asked by their auditor or another member of the organization. One additional procedure to consider when management does not have a thorough policy or records of time, is to look at job descriptions maintained by human resources or posted on their website. While not a perfect substitute, the position descriptions may provide information on how the organization expects employees in that role to spend their time, which can be compared to what has been allocated. How often percentages used to allocate costs are changed. While a good estimate process should involve continually gathering new information to refine and improve the process used in making the estimate, when significant changes are made without appropriate support, consideration as to whether management is attempting to achieve a predetermined result from the allocation needs to be considered. On the other hand, if management has not updated their allocation percentages in many years, there is an increased potential that the estimates are no longer accurate for allocation purposes. Awareness of biases in allocations based on time and effort. Many entities have an inherent bias that more costs being allocated to programming is viewed more favorably by charity rating agencies and donors than having higher M&G and fundraising costs. The prevalence of this bias is reflected in open letters written by several well know charity rating agencies describing it as the Overhead Myth. Consideration as to whether allocation needs to be based on an estimate in the first place. Many organizations that have been allocating costs for decades have been doing so based on long-standing estimates because better information was not available. However, if better information is now available related to the cost, it may be a direct cost and no estimate of cost allocation would be required. Consider for example depreciation expense, which may have historically been allocated on

8 square footage. If, however, you have information available related to certain assets being used exclusively by one activity (perhaps specific laptops or equipment), depreciation of those items would not need to be allocated alongside assets with more general use (office space, desk chairs, conference room furniture, etc.). Obtaining appropriate supporting documentation for allocations based on measurable criteria, such as actual hours spent or square footage as well as assessing if those measures are the best indicators of how the item being allocated is used. Effective Date and Transition The amendments are effective for annual financial statements issued for fiscal years beginning after December 15, 2017, and for interim periods within fiscal years beginning after December 15, Application to interim financial statements is permitted but not required in the initial year of application. Early application is permitted. The amendments should be initially adopted only for an annual fiscal period or for the first interim period within the fiscal year of adoption. NFP organizations will apply the ASU s guidance retrospectively. If presenting comparative financial statements, an NFP can elect to omit the analysis of expenses by both natural classification and functional classification (the separate presentation of expenses by functional classification and expenses by natural classification is still required). NFPs that previously were required to present a statement of functional expenses do not have the option to omit this analysis; however, they may present the comparative period information in any of the formats permitted in this ASU, consistent with the presentation in the period of adoption. Conclusion The financial statements are an opportunity for an NFP organization to tell the story of their organization. The types of changes which are included in ASU have not been made in many years, and represent an excellent opportunity for organizations to rethink what they ve always done in many areas, including the methods they have used for allocation. As you work with management to implement the changes, they should be encouraged to rethink processes in this area and consider if those processes support the allocation methods being used. 1 Portions of this report are adapted from a presentation delivered by Louis Mezzina and David Gagnon titled Expense Allocations and the New ASU. The presentation was delivered on June 21, 2017 at the AICPA Not-for-Profit Industry conference.

9 Center for Plain English Accounting aicpa.org/cpea The CPEA provides non-authoritative guidance on accounting, auditing, attestation, and SSARS standards. Official AICPA positions are determined through certain specific committee procedures, due process and extensive deliberation. The views expressed by CPEA staff in this report are expressed for the purposes of providing member services and other purposes, but not for the purposes of providing accounting services or practicing public accounting. The CPEA makes no warranties or representations concerning the accuracy of any reports issued. Copyright 2017 by American Institute of Certified Public Accountants, Inc. New York, NY All rights reserved. For information about the procedure for requesting permission to make copies of any part of this work, please with your request. Otherwise, requests should be written and mailed to the Center for Plain English Accounting, AICPA, 220 Leigh Farm Road, Durham, NC