Functional accounting classifies expenses by functional area in compliance with unique reporting requirements for nonprofits and the Statement of Functional Expenses. Take a deep dive into nonprofit functional accounting.
Functional Accounting Methods
Nonprofit Functional Accounting classifies expenses related to major activities in operating your nonprofit organization. These consist of (1) Support Services such as administration and fundraising; (2) Program Services which are mission-based.
What are nonprofit functional areas?
Nonprofit functional areas consist of Support Services and Program Services.
- Support Services
- Management and General – Day to day administrative activities such as management, accounting, human resources and governance.
- Fundraising – Activities related to appeals for support through donations and fundraising events.
- Program Services
- Activities related to providing the services for your mission.
What are functional expenses?
Nonprofit functional accounting easily allows your organization to identify three key elements that identify every dollar that comes into and goes out of your organization, answering the Who, What and Why of nonprofit reporting requirements.
- Income: Who is providing the dollar – funder
- Expense: Who is paying for an expense – funder
- Income: What type of income is it – grant, contract, earned revenue
- Expense: What will dollars be spent on – payroll, supplies, etc.
- Income: Why they are providing the dollar – which program or purpose
- Expense: Why the dollar is being spent – which program or purpose
Readers of your financial statements, such as donors are interested in understanding the relationship between an organization’s program expenses and its supporting expenses. This helps answer the “what” and “why” questions regarding an organization’s expenses. It is also required for the IRS Form 990 which asks nonprofits to divide expenses by Support Services and Program Services.
What are the benefits of functional accounting?
Functional accounting places the “who” and the “what” of each dollar in the “why”, which is either support services or programs designated for that dollar. If you use functional accounting, you can easily monitor each dollar coming in and going out. To get started, begin with your mission. Study your goals and value statements and determine how your nonprofit is organized. Identify the larger purposes for which you spend the most time and money.
For any organization that undergoes an annual nonprofit audit, their financial statements must be presented by functional area, or the CPA will be required to qualify their opinion, stating the statements were not prepared in accordance with generally accepted accounting principles.
Keeping track of functional expenses also facilitates the preparation of a statement of functional expenses, which is required as part of an audit. Tracking functional expenses is also an excellent tool for decision-making and transparency. It gives you a bird’s eye view of exactly what each activity is costing, helps to determine what is working, and what is sustainable.
Classification of Nonprofit Expenses
Another key component of nonprofit accounting is the classification of expenses. All businesses have expenses for salaries, payroll taxes, rent, utilities and supplies, but a nonprofit must classify those expenses into three functional areas – management and general and fund raising which are called support services and program which is how much money is actually spent on their mission.
This breakdown is required for financial statement presentation to the general public and on the nonprofit’s annual IRS Form 990 report. Functional expense reporting is another important financial measurement for the nonprofit. It provides information on how much of their resources are dedicated to their mission.
Common mistakes made when classifying expenses
A lot of organizations mistakenly classify their expenses only on the who element, by focusing on the funding source rather than the why the expense was incurred. If used properly, functional accounting can classify all three elements of the who, why and what with appropriate account number segments in your chart of accounts. Each transaction coming into or going out of the organization should be identified with an account code corresponding to the funding source (who), the revenue or expense category (what) and the functional area (why) of that transaction.
Statement of Functional Expenses for Nonprofits
The statement of functional expenses tracks real costs by categorizing expenses by functional area: mission-based programs and support services such as administration and fundraising.
As a subsidiary report to your financial statement, the Statement of Functional Expenses is a detailed list of the nature of each expense (salaries, payroll taxes, rent, professional services) by functional area. This report is necessary also when comparing actual expenses to budgets in each of your functional areas.
Besides the regulatory requirements of reporting by functional area, the most important reason to report on functional expenses is it is an ideal method for tracking the real costs of program and supporting activities, making it an invaluable tool for decision-making. It allows you to see exactly what each of your individual programs is costing, whether your fundraising is proportionate to the areas that need it, and whether a specific program is sustainable.
With nonprofit functional accounting you can easily identify each transaction coming in or going out with an amount that corresponds to the who, what and why of each transaction. This will help you generate higher quality and accurate reports. If your current accounting methods cannot accomplish this then you might want to consider a nonprofit accounting software package that incorporates functional accounting methods. This is part of the framework of knowing the answers to nonprofit organization accounting questions.
By integrating these elements into your nonprofit accounting system, the easier it will be to generate more accurate and relevant financial statements both internally and externally. This will make it easier to report on each of your organization’s programs and determine which programs are running efficiently and effectively. A detailed functional report will provide management with the information needed to make more informed decisions on your organization’s financial health.
If your current accounting system cannot generate functional reports by program and support services, and by funding source, then you should consider evaluating your present system and investing in an upgrade of your financial software such as FastFund Accounting.
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