Statement of Functional Expenses for Nonprofit Financial Transparency

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, analyzes and reports their accounting practices.

Join our Blackbaud nonprofit financial software training team at Capital Business Solutions as we explore the must-know information for creating a statement of functional expenses as a charitable organization.

Functional Expenses for Nonprofit Accounting

The Financial Accounting Standards Board requires that all organizations within the nonprofit sector 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. 

Types of Financial Statements for Nonprofits

Nonprofits use the following types of financial statements to report on their organization’s financial health:

• Statement of Financial Position (Balance Sheet):
  • Provides a snapshot of the nonprofit’s assets, liabilities, and net assets at a given point in time
  • Illustrates how resources are allocated and reveals the overall financial stability of the organization
• Statement of Activities (Income Statement):
  • Summarizes revenues, expenses, and changes in net assets over a reporting period
  • Helps stakeholders understand the impact of operational activities and informs future budgeting decisions
• Cash Flow Statement:
  • Details cash inflows and outflows from operating, investing, and financing activities
  • Assists in tracking liquidity and identifying potential cash management issues to ensure day-to-day financial stability
• Statement of Functional Expenses:
  • Breaks down expenses by function (e.g., program services, management and general, fundraising) and nature
  • Demonstrates compliance with donor restrictions and accounting standards by showing how resources are specifically allocated to support the organization’s success and mission

Functional Expenses vs Natural Expenses

When it comes to managing nonprofit financial data, 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 for nonprofit or for profit accounting practices, but only nonprofits are required to file their functional expenses. 

What Are Natural Expenses?

Natural expenses refer to the classification of costs based on their inherent nature, rather than by the function they serve. These include:

• Salaries and wages
• Office supplies
• Rent and utilities
• Maintenance and repairs
• Insurance premiums

What Are Functional Expenses?

Functional expenses are business expenses classified by function. For example:

• Programs: An activity created to fulfill the mission of the nonprofit. 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.
• Fundraising: The expenses associated with putting together a fundraising event, from the cost of invitations, or the refreshments served at a gala, etc.

Why Track Functional Expenses for Nonprofits?

Despite all the good an organization may do, they still need to maintain accurate nonprofit bookkeeping methods and accurate reporting of financial information to the government entities.

The reasons nonprofit organizations must effectively track functional expenses are: 

• To follow the law: All nonprofit organizations must file a tax form 990 each year with the IRS to report expenses and ensure compliance. 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 statement of function expenses report to pass independent audits. 
• To build public trust: To build trust with the communities you serve, it’s important for nonprofits to be transparent about where their money comes from and how it is spent.

The Role of Fund Accounting Practices

Fund accounting plays a critical role in nonprofit financial management by ensuring that every dollar is tracked according to its intended purpose. It involves separating financial resources into distinct categories or funds, each with its own set of restrictions and designated uses. This accounting system method is essential for maintaining transparency, accountability, and compliance with donor requirements and regulatory standards.

Here’s how fund accounting supports the overall financial health and reporting of a nonprofit organization:

• Accurate Allocation of Resources: Fund accounting segregates restricted funds from unrestricted funds, ensuring that each dollar is used only for its intended purpose.
• Enhanced Financial Transparency: Individual fund tracking produces detailed reports that reinforce stakeholder confidence during audits.
• Improved Budgeting and Decision-Making: Detailed fund tracking provides a clear view of available resources and fundraising expenses, enabling the organization’s future financial decision making.
• Audit Readiness and Compliance: Organized fund-specific records simplify audits by clearly demonstrating compliance with donor restrictions.
• Support for Financial Reporting: Fund accounting underpins comprehensive statements of the nonprofit’s finances, accurately allocating expenses across functions.

How to Create a Nonprofit Statement of Functional Expenses

Creating a nonprofit statement of functional expenses is a critical process to demonstrate financial accountability and ensure compliance with accounting standards.

Step 1: Gather Financial Documentation

Collect all financial records, invoices, receipts, and statements from the relevant accounting periods to build a comprehensive database. Accurate documentation is the foundation for efficiently classifying and summarizing your expenses.

Step 2: Categorize Expenses by Function

Separate expenses into categories based on their designated purpose, such as program services, management and general, and fundraising costs. This categorization allows you to reflect how each expense contributes to the nonprofit’s mission and overall operations.

Step 3: Categorize Expenses by Nature

Break down each functional expense into natural expense categories like salaries, rent, utilities, and supplies. Detailing expenses by their inherent character provides a clear picture of what is driving the cost structure in your organization.

Step 4: Allocate Indirect Costs

Identify and allocate shared or indirect expenses across the different functional categories using reasonable allocation methods. This ensures that overhead costs are fairly distributed, giving stakeholders a more accurate view of each function’s spending.

Step 5: Compile the Statement

Organize the categorized and allocated information into a formal statement that clearly lists each expense under the corresponding function. Ensure that the statement follows recognized nonprofit accounting standards to facilitate clarity and compliance.

Step 6: Review and Validate the Data

Conduct a thorough review of the compiled statement to check for consistency, accuracy, and proper classification of expenses. Verification by cross-referencing original financial documentation enhances reliability and prepares the statement for audits.

Step 7: Present the Final Statement

Once validated, format the statement in a clear, accessible manner for stakeholders, board members, and auditors. An accurate and well-prepared statement of functional expenses not only meets regulatory requirements but also supports strategic decision-making and builds donor trust.

How Blackbaud’s Software Accounting Solutions Support Nonprofits

Nonprofit accounting software is game changers for organizations striving to manage their finances with precision, transparency, and efficiency. Among the market leaders, Blackbaud’s Financial Edge NXT stands out for its key features designed specifically for nonprofit needs.

Here’s how Financial Edge NXT supports not-for-profit organization’s missions:

• Streamlined Financial Management: Financial Edge NXT automates data entry, reconciliations, and report generation to reduce human error, speed up month-end closings, and enhance control over funds.
• Enhanced Transparency and Compliance: It provides detailed tracking of donor-restricted and program funds with comprehensive audit trails and customizable reporting, ensuring clear accountability.
• Improved Decision-Making Through Real-Time Data: Real-time dashboards and analytics empower nonprofit leaders to monitor key financial metrics and respond swiftly to challenges and opportunities.
• Scalable and User-Friendly Platform: Designed for nonprofits of all sizes, Financial Edge NXT is both scalable and intuitive, facilitating seamless access to critical financial information and better team collaboration with an easy to use interface.

Specialized Training and Support for Financial Edge NXT

Capital Business Solutions is dedicated to supporting nonprofits through specialized education and training programs designed to optimize the use of Financial Edge NXT from Blackbaud. With our nonprofit accountant led training sessions, we empower nonprofit teams to fully leverage the software’s features to reach their financial goals.

With expert guidance and ongoing support, nonprofits can maximize their investment in Financial Edge NXT, enhancing overall financial management and accountability.

Learn More About Our Accounting Software Training Today

Maximize your nonprofit’s potential by maintaining accurate records with the use of Financial Edge NXT accounting software. To learn more about our nonprofit software training and expert-led programs contact our team today.

Get started now by calling  (843) 971-9061 or filling out our easy-to-use online contact form.