With June 30 just behind us and so many not-for-profit organizations beginning their financial statement close process, functional expense classification is front of mind for many. Not-for-profit organizations are required to report expenses according to the purpose for which they are incurred, called functional allocation of expenses. There are two broad categories of functional expenses, which can then be further detailed in the financial reporting process. Program service expenses are costs associated with activities resulting in goods and services provided to beneficiaries, customers or members fulfilling the mission of the organization. Supporting service expenses are costs related to administering the day-to-day activities of the organization (management and general activities).
Under the current accounting standards, before adopting the new not-for-profit reporting model, functional expenses can be disclosed in the statement of activities, the footnotes or a separate statement of functional expenses.
As part of good governance, we recommend formalizing a policy in writing. Review the policy at least quarterly. Identify the type of transactions that are directly allocated versus indirectly allocated (things like rent, utilities or other similar costs). For allocated expenses, develop a policy that is logical and reasonable for the type of expense, such as a square-footage process. Maintain timesheets for individuals with allocated expenses, as their time may be split between program service expenses and supporting service expenses. Ensure that you apply the policy consistently year over year to allow for comparability.
Functional expenses are of great interest to users of not-for-profit financial statements, as the disclosure tells the story of how the organization is utilizing resources based upon its mission statement. Under the new not-for-profit standard, which is effective for annual financial statements issued for fiscal years beginning after December 1, 2017, organizations will be required to disclose expenses in natural and functional classification in the same statement and provide disclosure on the methodologies used to allocate expenses. Focusing on the functional expense disclosure now will assist in adoption of the new standard.