What are Nonprofit Statement of Functional Expenses

When most people think about nonprofit organizations, they do not think about the accounting needs and financial reports needed to track the spending, earnings, and economic trends of the corporation. We tend to think about nonprofit businesses as non-financial businesses, which is a colossal error. Every company, whether for-profit or nonprofit, has accounting needs to analyze and report the organization’s expenses.  

Nonprofit organizations are businesses that do not operate with the goal of making a profit as a for-profit business would, but nonprofit businesses have many ways that they earn as well as spend money. These financial transactions need to be reported through what is called a nonprofit statement of functional expenses. Our experienced nonprofit accountants at Capital Business Solutions have all the details you need to create a statement of functional expenses for your or your client’s nonprofit business. 

What Are Functional Expenses? 

The Financial Accounting Standards Board requires that all nonprofit businesses report their expenses based on both nature and function. In other words, nonprofit organizations must provide an analysis of how their resources were spent and for what purpose(s). The way this is done is by creating what is called a financial statement. 

Nonprofits use the following types of financial statements to report their financial data: 

• Statement of financial position: similar to a balance sheet, where assets, liabilities, and net assets are reported. 
• Statement of activities: similar to a standard income statement, looking at both revenue and expenses. 
• Statement of cash flow: just like a regular cash flow statement, this also looks at the revenue and expenses of the organization. 
• Statement of functional expenses: a report that analyzes expenses by looking at functional classifications. 

Because the money that comes from nonprofit businesses is the result of grants, fundraisers, donations, and campaigns, not-for-profit organizations must report their expenses differently than a for-profit business would. 

Functional Expenses vs Natural Expenses 

Nonprofit organizations are required to report their financial activities in two ways: a report of their natural expenses and a report of their functional expenses. Natural expenses are reported by all businesses, whether nonprofit or for-profit, but only nonprofits are required to file their functional expenses. 

Natural expenses are categorized by their natural classifications– for instance, employee salaries, rent, utilities, maintenance, and the cost of supplies are all examples of natural expenses. 

Functional expenses are business expenses classified by function– functional expenses would fall into one of the following categories: 

• Programs: An activity created to fulfill the mission of the nonprofit business, some nonprofits may have one program or several programs, but expenses for each separate program need to be separately reported. 
• Management/General expenses: Expenses not attached to one specific program, but the nonprofit organization as a whole are classified as management expenses– items like the salary of the chief officer of the organization would be classified here. 
• Fundraising: Do not make the mistake of looking at fundraising only as money coming in, when in reality fundraising comes at a cost to the nonprofit organization– the expenses of putting together a fundraising event, from the cost of invitations or the refreshments served at a gala, fundraising comes at an expense to the nonprofit business itself. 

Why Track Functional Expenses for Nonprofits?

The purpose of nonprofit organizations is to fulfill missions that aim to solve specific problems in our society– a mission might be to combat hunger across the globe, to help at-risk youth, to support homeless individuals in securing a job, or to collect goods for people in need, among endless other potential missions that a nonprofit may aim to serve. Despite all of the good that nonprofits do, they still need to accurately report their expenses to the government through a statement of functional expenses. 

The reasons nonprofit organizations must track functional expenses are: 

• To follow the law: All nonprofit organizations must file a form 990 each year with the IRS to report expenses. If an organization fails to report for 3 consecutive years, it will lose its tax-exempt status. 
• To pass independent audits: Generally Accepted Accounting Principles (GAAP) require a functional expense report to pass independent audits. 
• To build public trust: To build trust with the communities you serve, it’s important to be completely transparent about where the money comes from and where it goes for a nonprofit organization. 

How to Create a Nonprofit Statement of Functional Expenses

A statement of functional expenses is a matrix-style report that breaks down all of the natural and functional expenses of the nonprofit organization into one easily readable table. Nonprofit accountants need to know how to help their clients create a statement of functional expenses. If an organization is set up with adequate nonprofit accounting software, the process of creating a statement of functional expenses can be quite simple. 

Allocation Methods for Nonprofit Functional Expenses 

A nonprofit accountant creating a functional expense report for a nonprofit business first needs to classify each expense by its functional classification. While nonprofit functional expenses may be easily categorized, there are a few allocation methods that nonprofit organizations can use to build their functional expenses report. 

Part of building trust with the community, donors, board of governors, and other stakeholders is to be transparent in how the nonprofit organization’s expenses drive support for its missions and programs. 

Allocation Method #1: Area/Square Footage

This allocation method focuses on space and square footage as the criteria to determine the expenses of a nonprofit business. In order to rent office space, the nonprofit business must pay for rent and utilities. Looking at the area, the organization sees how the total square footage of the office space compares to the number of offices occupied by specific departments. For example, depending on how much of the office space is used by the fundraising department, the organization can see how much of its rent expenses should be allocated toward the fundraising department. 

Allocation Method #2: Count Per Person

Looking at the number of people working on each program at the nonprofit business and the expenses they accrue, one can determine each individual employee’s and program’s expenses. This allocation method is only effective for nonprofits with a small number of employees, often that does not exceed more than a thousand employees. 

Allocation Method #3: Time Studies

A nonprofit organization can have each employee record how they spend their time– looking specifically at how much time is spent between fundraising, general management, and programs. This information can then be used to allocate future spending. 

Allocation Method #4: Direct Cost

Direct costs refer to expenses that can only relate to one classification– for example, grant payments are costs related to one department or specific program. 

The Role of Nonprofit Accountants in Creating Nonprofit Statements of Functional Expenses 

If you are new to nonprofit accounting, your first step is to understand the basic principles and needs of statements of functional expenses. This includes understanding how to allocate functional expenses into classifications to build a functional expense report. 

Nonprofit accountants should have a basic understanding of nonprofit fundraising software, and how to help their clients keep up-to-date records of expenses through the use of these software solutions. Capital Business Solution’s nonprofit fundraising software training assists in understanding how to prepare financial reports for nonprofit organizations.   

Get Help Creating Nonprofit Statements of Functional Expenses Today! 

As nonprofit accountants, it’s vital to know the ways to report expenses to the IRS for your nonprofit clients, and one of the most important parts of that is understanding the role of a statement of functional expenses. 

If you are a nonprofit accountant or if you work for a nonprofit business and need help preparing a statement of functional expenses, Capital Business Solutions has the answers. We are your source of nonprofit accounting software and nonprofit accounting software consulting services. Our nonprofit accountants have had success in providing complete and accurate statements of functional expenses for nonprofit businesses. 

Contact us today at  (843) 971-9061 or fill out our contact form below to get started.