Nonprofit Financial Reporting – Functional Expenses
Salaries, supplies, professional fees, occupancy, and other expenditures are necessary expenses of all organizations. However, nonprofit organizations present these expenses differently from their for-profit counterparts. To help users of nonprofit financial statements understand not only what was purchased but why it was purchased, U.S. Generally Accepted Accounting Principles (U.S. GAAP) require nonprofits to disclose expenses by both natural and functional classifications. Under Financial Accounting Standards Board Accounting Standards Codification (FASB ASC) Subtopic 958-720, Not-for-Profit Entities – Other Expenses, natural classification describes the type of economic benefit received, while functional classification identifies the purpose for which the expense was incurred.
What Are the Differences?
The natural classification groups expenses based on the economic resource consumed. Common natural expenses include salaries and wages, employee benefits, insurance, occupancy costs, professional services, and depreciation. When analyzing expenses by natural classification, users of the financial statements can see what the organization is spending their resources on. Natural classification, however, provides limited insight into why the organization incurred an expense. Functional classification provides that additional context.
Functional expense classifications group expenses into two broad categories: program services and supporting activities. Supporting activities generally include management and general activities and fundraising activities, when applicable. The classifications most commonly presented are program services and management and general. Fundraising activities apply when an organization solicits contributions. These functional categories aim to answer why the organization incurred the expense.
The Functions
Program Services
Program expenses are costs incurred to carry out the organization’s mission through the delivery of services, programs, or other mission-related activities for beneficiaries, members, or customers.
Management and General
Management and general expenses include administrative and operational costs that are necessary to operate the organization but are not identifiable with a specific program service or fundraising activity.
Fundraising
Fundraising expenses are directly related to raising financial assets such as cash and securities, as well as nonfinancial assets, such as donated goods, services, facilities, and other resources to support the organization’s operations and programs.
Assignment and Allocation
Assigning expenses to a function requires analyzing the cost to determine whether it benefits a single function or more than one function. If a cost is directly related to a specific function, it should be assigned entirely to that function. For example, a local food bank purchases bags that will be used to portion groceries for distribution through its weekly food pantry. In this example, the expenditure is directly related to the organization’s program and, therefore, supports advancing its mission. The cost of mailers for an annual appeal would be assigned to fundraising because the purpose of the mailer is to raise funds for the organization.
Not all expenses are this straightforward and may require allocation among multiple functional classifications. A building lease is one example. Expanding on the local food bank example, portions of the leased space are used for beneficiaries to collect needed items (program services), by administrative staff (management and general), and by fundraising staff (fundraising). Although there is a single monthly lease expense, all functions benefit from the use of the space. Under U.S. GAAP, and consistent with ASC 958-720, organizations should use a reasonable and consistently applied allocation methodology when assigning shared costs that benefit multiple functions. For instance, square footage can be used as a basis and the percentage of space utilized by each function would be applied to the lease expense.
Continuing with the example, assume that monthly rent is $3,000 and the leased area totals 2,000 square feet. The beneficiary area is 1,000 square feet, administrative offices occupy 500 square feet, and the remaining 500 square feet is used for fundraising activities. Based on square footage, the monthly rent would be allocated as follows: $1,500 program services (50%), $750 for management and general activities (25%), and $750 for fundraising activities (25%).
The example above provides a reasonable allocation methodology that should be consistently applied from period to period. If the use of the space changes, the allocation percentages should be updated to reflect current usage.
Allocating costs across multiple functions requires judgement, and no single allocation basis is appropriate for every expense or organization. Although shared costs may require allocation, a methodology used by one nonprofit may not be appropriate for another. Allocations should be supported by current information and be revisited periodically as the organization’s activities, staffing, facilities, or operations change.
Reporting
U.S. GAAP requires nonprofit organizations to present an analysis of expenses that shows the relationship between natural and functional classifications in one location. The analysis may appear on the face of the statement of activities, in the notes to financial statements, or in a separate statement of functional expenses. A separate statement of functional expenses is a common presentation because it clearly displays the relationship between natural and functional expense classifications.
A well-designed chart of accounts can aid in more efficient reporting by capturing natural and functional information throughout the year.
Final Thoughts
Reporting functional expenses provides transparency into how an organization uses its resources and demonstrates responsible stewardship to donors, grantors, regulators, and other stakeholders. This reporting helps tell the nonprofit’s story and demonstrates its impact on the communities it serves.
Financial statements are not the only place where users will see functional expenses; this information also appears on the organization’s federal Form 990. It is important to note that amounts reported on Form 990 may not agree directly with an organization’s financial statements because of differences between U.S. GAAP reporting requirements and IRS reporting rules.
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