Understanding Functional Expenses Part 1 of 4

Essentially, anyone interested in understanding the financial operations of a non-profit organization will find this guide useful. To avoid misclassification, it’s important to understand the contribution margin nature of each expense and the appropriate accounting treatment. Using detailed a chart of accounts, maintaining organized records, and regularly reviewing and reconciling accounts can also help prevent this mistake.

Fundraising Expenses per Form 990

A company selling merchandise on credit will record these sales in a Sales account and in an Accounts Receivable account. Examples of budgets used in business include the cash budget, sales budget, production budget, department budgets, the master budget, and the capital expenditures budget. Some budgets are designed to be flexible budgets, while others are static budgets.

• The variance report can remain an internal document but should be saved for future reference.
• These include expenses that keep your organization running smoothly, such as office supplies, legal fees, executive salaries, and accounting services.
• Accurate documentation is the foundation for efficiently classifying and summarizing your expenses.
• Sage makes no representations or warranties of any kind, express or implied, about the completeness or accuracy of this article and related content.
• The most common benchmarks to allocate these expenses are time and effort for payroll costs and square footage for occupancy costs.
• Understanding the three categories of functional expenses is critical for maintaining transparency and compliance within a nonprofit organization.

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• By following a structured format and categorizing expenses accurately, nonprofits can meet regulatory requirements, maintain transparency, and improve financial planning.
• A statement of functional expenses, sometimes referred to as a schedule of functional expenses, is a financial report that details how your nonprofit allocates costs across different categories.
• Each of the general functional expense categories can be further broken down to specific subgroups that more clearly classify the nature of the organization’s expenses.
• While the statement of cash flows, or cash flow statement, may be a bit difficult to prepare, it is an important financial statement to be read.
• Additionally, your financial statements won’t be compliant with generally accepted accounting principles (GAAP) if you don’t present a functional expense allocation.

Functional expense reporting is a crucial aspect of nonprofit accounting, providing transparency and accountability in distinguishing program costs from administrative expenses. This classification helps stakeholders understand how resources are allocated and ensures that funds are being used effectively to achieve the organization’s mission. Accurate functional expense reporting aids in compliance with regulatory requirements and enhances the credibility of financial statements. One natural expense type will often fall under multiple functional expense classifications.

• From churches to youth organizations to the local chambers of commerce, nonprofit organizations make our communities more livable places.
• It helps leadership understand the full costs of each function, which aids in strategic decision-making and budgeting.
• Continuous education and updates on regulatory changes also help maintain compliance and accuracy.
• Typical readers include donors, grantors, organizational leaders, rating agencies, and the press.
• Our in-depth guide is designed to assist non-profit organization leaders, financial managers, donors, potential funders, and regulatory bodies.
• The plan should act as a formal document that is reviewed and updated for efficiency as often as necessary, but at least annually.

Illustration of the Statement of Financial Position and the Statement of Activities

The detail in the general ledger accounts will always be available for management’s use. However, the account balances will be combined into a few amounts that are presented in the financial statements and IRS Form 990. Under the accrual method of accounting, expenses are to be reported in the accounting period in which they best match the related revenues. If that is not clear, then the expenses should be reported in the period in which they are used up. If there is uncertainty as to when an expense is matched or is used up, the amount spent should be reported as an expense in the current period. Our intent is to merely introduce some Record Keeping for Small Business of the basic concepts that are unique to nonprofit accounting and reporting that are required by the Financial Accounting Standards Board (FASB).

As a result, this ensures they direct the majority of their funds toward program services. Donors often look at the ratio of fundraising expenses to total expenses to gauge the efficiency of a nonprofit. The statement of functional expenses tracks costs by classifying them into mission-based programs and support services, including administration and fundraising. In other words, it’s like a financial map that shows how an organization is spending its money. In nonprofit accounting, functional expense allocation means distributing shared costs across different functional categories, such as program services, management, and fundraising. The audience of an organization’s financial reporting includes funders, donors, boards of governors and regulators.

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• It may be tempting to create a class for every sub program, but keep in mind somebody has to make decisions about how to enter expenses to these classes.
• However, this approach only works for a smaller organization with less employees or workers.
• So a clean audit opinion can’t be obtained without clearly stating this information.
• By comparing the report with your predictions from the previous year, you can make more accurate projections when allocating expenses for the coming year.
• Topic 958 not only requires disclosure of expenses by natural and functional classification, but also requires disclosure of the allocation methods in the notes to the financial statements.
• Functional expense reporting confuses many first-time nonprofit bookkeepers and executives.

Program costs are directly related to the mission-driven activities of the organization. These expenses include salaries for program staff, supplies, and other resources essential for delivering services. Functional expense allocation can be done on the face of the statement of activities, in the notes to the financial statements, or as a separate statement of functional expenses (SFE). Most nonprofit organizations that have more than one program find the SFE the most effective method of recording expenses. The inclusion of functional expense information in financial statements enhances transparency, allowing statement of functional expenses stakeholders to assess a nonprofit’s commitment to its mission through its financial practices. Allocating expenses by function is an unavoidable part of running a nonprofit organization.