What Are Functional Expenses? A Guide to Nonprofit Accounting
Functional expenses are reported by their functional classification and recorded in a Statement of Functional Expenses. This method of expense reporting is most commonly used by nonprofit organizations.
Here are some key nonprofit accounting principles to help you understand functional expenses:
NOTE: FreshBooks Support team members are not certified income tax or accounting professionals and cannot provide advice in these areas, outside of supporting questions about FreshBooks. If you need income tax advice please contact an accountant in your area.
What Are Functional Expenses?
Functional expenses are reported by their functional classification. All nonprofit organizations in the US are now required to report their expenses based on their functional classification and by the natural classification, as per Financial Accounting Standards Board guidelines.
What are functional expenses and what are natural expenses? You can think of it this way: functional expenses describe the purpose of an expense by its category, while natural classifications explain what the money was spent on.
Functional Classifications Versus Natural Classifications
Nonprofit organizations report their expenses by both functional and natural class. Organizations record expenses according to these functional classifications:
Program expenses are any costs related to running the various programs and services offered by a nonprofit organization, as per its mission. For established nonprofits, program expenses often make up the majority of their overall costs.
Management and General
Management and general costs are supporting expenses associated with funding the day-to-day operations of the organization. These expenses don’t directly relate to the mission of the nonprofit and usually include costs like governance, bookkeeping and management.
Fundraising costs are supporting expenses associated with an organization’s call for financial support or monetary contributions. This would include all expenses related to fundraising events, direct mail campaigns requesting donations and the salaries of employees working on fundraising.
Organizations then also present their expenses by natural classification, which can include:
- Office rent
- Office supplies
The Statement of Functional Expenses that nonprofits issue is referred to as a matrix, because it requires organizations to report their expenses by both functional and natural classification.
Nonprofit accounting differs from business accounting, because nonprofits don’t exist to make profits. They instead fulfill missions aimed at addressing specific needs in our society.
It’s crucial that nonprofit organizations understand how to properly record functional expenses to ensure they’re acting in accordance with federal regulations.
Statement of Functional Expenses Example
Preparing a Statement of Functional Expenses for a nonprofit organization can seem intimidating, since it involves reporting expenses across two classifications. Here’s an example of a Statement of Functional Expenses prepared by Accounting Coach, to show you what the report looks like in action:
As you can see, the column headings highlighted in green show the expenses by function. The first column highlighted in blue shows the nature of the expenses.
What Is Functional Expense Allocation?
Functional expense allocation is the process by which a nonprofit organization’s accountant or bookkeeper classifies each expense by its functional classification. To better grasp functional expense allocation, it helps to understand why it’s important for nonprofit organizations in particular to report their expenses by function.
The audience of an organization’s financial reporting includes funders, donors, boards of governors and regulators. These stakeholders are mainly interested in the relationship between a nonprofit organization’s program expenses and its supporting expenses. They want to see how an organization’s supporting costs relate to and drive its programs.
Functional expense allocation makes it clear to an organization’s stakeholders how its natural expenses help support the organization’s programs and services.
There are different allocation methods for functional expenses, including:
- Square Feet: For natural costs including rent and utilities, expenses can be allocated based on the square footage that an organization’s departments occupy. For example, a nonprofit could compare the total square footage of its office space to the square feet that its fundraising department occupies. The difference can help the organization determine what percentage of its rent should be allocated to Fundraising.
- Headcount: Small organizations or those with staff that work remotely often find it easiest to allocate expenses based on headcount. To do this, the percentage of people working on each program is used to allocate expenses.
- Time Studies: Some organizations choose to have each employee record how they spend their time within a pay period. The nonprofit can then calculate the average amount of time each employee spends working on its programs, management and fundraising. That information can then be used to allocate costs on an annual basis.
- Direct Costs: There are some expenses that only relate to one classification type for a specific program, such as grant payments. These expenses can be allocated directly.
What Financial Statements Do Nonprofits Issue?
Nonprofit organizations release financial statements that differ from those issued by businesses. Nonprofit organizations issue the following financial statements:
Statement of Financial Position
In the world of nonprofits, the Statement of Financial Position serves a similar role to that of a balance sheet for businesses. The Statement of Financial Position lists the values of all assets held by the organization and the value of all the debt owed. It also includes the nonprofit’s net assets, which demonstrates the overall value of the organization, similar to the equity reported by businesses.
Statement of Functional Expenses
The Statement Of Functional Expenses explains the costs incurred for each functional area of the organization. The functional classifications include: programs, management and general and fundraising.
Statement of Activities
The Statement Of Activities is similar to the Income Statement businesses issue. The Statement of Activities looks at the entire organization and reports on the revenues and expenses of the nonprofit during a specific reporting period.
Statement of Cash Flows
The Statement Of Cash Flows reports on all cash flowing into and out of the nonprofit organization. Specifically, the statement demonstrates the extent to which the organization’s programs and activities generate and use money.