Ducharme Article – GRAP 1 Classification of Expenditure

Financial statements tell the story of how the entity has spent the money it earned during the financial year. This story needs to reflect fairly the results of the operations. A fair presentation of expenses is key to forming an understanding of the entity’s operations and their financial effect. GRAP 1 is the Standard that deals with the Presentation of Financial Statements. Financial statements are made up of the elements: assets, liabilities, revenue and expenses. GRAP 1 set out requirements for a consistent presentation and disclosures for expenditure. Which one is better: classification by nature or by function? The linked Ducharme article sets out more information and considerations to the GRAP 1 classification.

GRAP 1: PRESENTATION OF FINANCIAL STATEMENTS: EXPENDITURE BY NATURE OR FUNCTION

Financial statements tell the story of how the entity has spent the money it earned during the financial year. This story needs to reflect fairly the results of the operations. A fair presentation of expenses is key to forming an understanding of the entity’s operations and their financial effect. GRAP 1 is the Standard that deals with the Presentation of Financial Statements. Financial statements are made up of the elements: assets, liabilities, revenue and expenses.

GRAP 1, paragraphs 36 states: “.36 Each material class of similar items shall be presented separately in the financial statements. Items of a dissimilar nature or function shall be presented separately unless they are immaterial.”

This is the first time we see the requirement in the Standards that the financial statement items should be organised along similarity of nature or function of those items.

The word “nature” is not explicitly defined in GRAP.   The Oxford Dictionary defines it as: “The basic or inherent features, character, or qualities of something.” (https://www.lexico.com/en/definition/nature).

“Function” is defined as: “An activity that is natural to or the purpose of a person or thing” (https://www.lexico.com/en/definition/function)

So, in layman’s terms, nature is what an item is, and function is what it does.

If applied to financial statement line items, things like assets are easily organised according to their nature. Items of property, plant and equipment have physical substance which provides for the usefulness. Take a car for example. It can transport people physically from one place to the next. Therefore, the nature of items, such as vehicles, help us to organise them as part of PPE. A car is an asset, but its function is transport.

What about expenditure?

How easy is it to organise expenditure items according to their nature or function?

Firstly, the requirement from GRAP 1, in addition to paragraph 36:

“.104 An entity shall present an analysis of expenses using a classification based on either the nature of expenses or their function within the entity, whichever provides information that is reliable and more relevant.”

However, this requirement has not been applied consistently across the GRAP reporting world. The research paper issued by the Accounting Standards Board, Research Paper on Presentation of Information in the Statement of Financial performance (July 2018), highlighted this as follows:

“GRAP 1.104 requires entities to present an analysis of expenses by nature or function. Analysing expenses by nature identifies expenses in terms of their character and groups expenses according to the kinds of economic benefits or service potential received in incurring those expenses, irrespective of their use in the entity’s operations or where the expenses are incurred. The function of expense method analyses expenses according to the programme, activity from which the item arises, or purpose for which they were incurred. The Secretariat of the ASB has issued an FAQ on this issue. The research found that the guidance is unhelpful because the Secretariat’s FAQ was new, and entities had not yet considered it. Other existing guidance and financial reforms that may have contributed to the incorrect presentation include:

• The National Treasury guideline on GRAP 1 includes “repairs and maintenance” as an item of expenditure presented by nature.

• The municipal standard chart of accounts (mSCOA) has an item for “contracted services”. Although mSCOA does not prescribe reporting in the financial statements, it led preparers to assume they should present “contracted services” as a line item.

• The Government Finance Statistics classification is not clearly by nature or function.

• Reporting requirements to, for example, the National Treasury include items such as “repairs and maintenance” and related ratios. Although this reporting is for specific purposes and a specific user, it led to preparers reporting similar information in general purpose financial statements.”

The Frequently Asked Question referred to above is FAQ 3.4 What does it mean to analyse expenditure by either nature or function?

This FAQ specifically identifies the following items of expenses as being inappropriately categorised by “nature” whereas these often coincide with specific functions performed in the entity:

• repairs and maintenance,

• grant expenditure,

• contracted services, and

• project expenditure.

Often, the chart of accounts is set up with these line items as accounts. If the general ledger for the above items are analysed, one would quickly find that the items may in fact include the true nature of the expenses, as follows (Item by function:   Nature of items included):

• • Repairs and maintenance:  Contractors; labour; materials; spare parts; etc.
  • Grant expenditure:    Cash paid; salaries paid; books provided; training courses; etc.
  • Contracted services:   Cleaning; security; garden; etc.
  • Project expenditure:    Professional fees; administration fees; materials; etc.

One exception though is when the entity procured a turn-key service from a company to provide all repairs and maintenance, for example. This may qualify as the nature of the expense.

A way to understand expenses by function better is to consider the programmes for which they are spent. Take a municipality for example, which offers services of water, electricity, sanitation and roads. When the statement of financial performance is presented according to the function of the expenses, one should expect a closer alignment between the programmes of the entity and the actual expenses. The approved budget which may be per programme, would also indicate the functions better.

So, which classification is better?

The entity should determine which presentation is best for its users. Entity’s that are broadly operating under a single mandate, may not benefit from an analysis by function. Similarly, entities with defined individual mandates or programmes, may be withholding useful information from its users if it presents only the nature of expenses.

However, GRAP 1.110 does require, when an analysis by function is presented, that the nature of the expenses should also be presented in a note. For example, Cost of Sales presented as an expense line per function on the face of the Statement of Financial Performance, requires a note to separate Cost of Sales into the nature of the items such as: Employee Costs, Depreciation of Production Equipment; Inventory consumed; etc.

Therefore, the presentation and disclosure of expenditure in the annual financial statements require careful consideration.

> Ducharme Technical Support Division