Demystifying the Statement of Functional Expenses: An In-Depth Guide for Preparation

For nonprofits, transparency and accountability are paramount. Donors, supporters, and regulatory bodies need to know how funds are being used to instill trust and ensure proper management. One key tool in this process is the Statement of Functional Expenses for nonprofits, a detailed report that breaks down an organization’s expenditures into categories such as program services, management, and fundraising. 

This blog post not only fulfills regulatory requirements but also provides valuable insights into the nonprofit’s operations and priorities. We will delve deeper into the importance, preparation, and components of the Statement of Functional Expenses, shedding light on this crucial aspect of nonprofit accounting.

What is the Statement of Functional Expenses?

The statement of functional expenses tracks costs by categorizing them into mission-based programs and support services, including administration and fundraising. It’s like a financial map that shows how an organization is spending its money. 

The statement breaks down the expenses into categories based on their function, such as program services, management and general expenses, and fundraising expenses. 

1. 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.
2. Program Services
   • Activities related to providing the services for your mission.

Definition and Purpose

The Statement of Functional Expenses is a key component of nonprofit accounting. It serves as a detailed roadmap, illustrating how an organization’s funds are allocated. By breaking down expenses based on their purpose, this statement provides a clear view of how resources are utilized to advance the mission.

Understanding the statement of functional expenses is essential for running a successful nonprofit. It fosters trust, and transparency, and ensures that donated funds are utilized effectively. Additionally, it provides valuable insights into cost allocation across various areas, aiding in planning and decision-making.

Definition and Purpose

The purpose of this statement is twofold. Firstly, it provides transparency for donors, members, and regulators by showing exactly how funds are being utilized within the organization. Secondly, it serves as a valuable management tool by helping the organization’s leadership understand the full costs of each function, which aids in strategic decision-making and budgeting.

Importance in Nonprofit Accounting

The Statement of Functional Expenses plays a vital role in nonprofit accounting for several reasons:

1. Transparency: This statement provides a detailed breakdown of expenses, which promotes transparency. Donors, potential funders, and regulatory bodies can see exactly how the organization is spending its money. This transparency can build trust and potentially attract more funding.
2. Accountability: By categorizing expenses according to their function, this statement holds the organization accountable for its spending. It ensures that funds are being used appropriately and efficiently towards achieving the organization’s mission.
3. Management Decision-Making: This statement is a useful tool for management. By understanding where the money is going, leaders can make informed decisions about budget allocations, cost control, and strategic planning.
4. Regulatory Compliance: Nonprofits are required by the Financial Accounting Standards Board (FASB) to report their expenses by nature and function. The Statement of Functional Expenses helps fulfill this requirement, ensuring the organization remains in good standing with regulators.

Key Components of the Statement of Functional Expenses

The Statement of Functional Expenses provides a detailed breakdown of a nonprofit organization’s financial activities. It includes components such as Program Services, Management and General Expenses, Fundraising Expenses, and Total Expenses. This statement offers insight into how resources are utilized to fulfill the organization’s mission effectively.

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.

1. Who
   • Income: Who is providing the dollar – funder
   • Expense: Who is paying for an expense – funder
2. What
   • Income: What type of income is it – grant, contract, earned revenue
   • Expense: What will dollars be spent on – payroll, supplies, etc?
3. Why
   • 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.

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What are Program Services Expenses?

Program Services Expenses in the Statement of Functional Expenses refer to the costs directly related to carrying out a nonprofit organization’s mission or purpose. These are the primary activities that the organization was created to perform. 

For example, for a nonprofit health clinic, program services expenses could include the costs of medical supplies and staff salaries. For an educational nonprofit, these expenses might involve costs associated with teaching, curriculum development, or student support services. 

These costs are crucial to track as they directly reflect the organization’s impact and effectiveness in achieving its stated goals. They also provide donors and stakeholders with a clear understanding of how funds are being used to serve the community or cause.

Here are some examples:

1. Educational Nonprofit: For an organization focused on adult literacy, program service expenses could include the cost of textbooks, educational software, tutor salaries, and rent for the learning center.
2. Healthcare Nonprofit: If the mission is to provide free medical care to underserved communities, program service expenses might include the salaries of doctors and nurses, the cost of medical supplies and equipment, and the expenses related to maintaining the clinic or mobile health units.
3. Environmental Nonprofit: For an organization dedicated to reforestation, program service expenses could include the cost of saplings, equipment for tree planting, transportation to planting sites, and salaries for field staff.

Management and General Expenses

Management and General Expenses, often referred to as overhead or administrative costs, are another important component of the Statement of Functional Expenses in a nonprofit organization. 

These expenses include all costs not directly linked to carrying out the organization’s mission but are necessary for overall operations and administration.

1. Salaries and Benefits: The compensation of personnel who are not directly involved in program services but perform essential administrative tasks such as accounting, human resources, or executive leadership.
2. Office Expenses: This may encompass rent, utilities, office supplies, and equipment that support the overall functioning of the organization.
3. Professional Services: Costs related to legal counsel, auditing, consulting, or other professional services that aid in the management and governance of the nonprofit.
4. Insurance and Licenses: Any fees associated with maintaining necessary insurance, licenses, or permits for the organization.

Examples include:

1. Salaries and Benefits: The compensation of personnel who are not directly involved in program services but perform essential administrative tasks such as accounting, human resources, or executive leadership.
2. Office Expenses: This may encompass rent, utilities, office supplies, and equipment that support the overall functioning of the organization.
3. Professional Services: Costs related to legal counsel, auditing, consulting, or other professional services that aid in the management and governance of the nonprofit.
4. Insurance and Licenses: Any fees associated with maintaining necessary insurance, licenses, or permits for the organization.

While these costs might not directly contribute to the mission, they are vital for the organization’s efficient running and long-term sustainability. It’s also important for nonprofits to maintain a reasonable ratio between program service expenses and management and general expenses to demonstrate effective use of funds to donors and stakeholders.

Fundraising Expenses

Fundraising Expenses are costs incurred by a nonprofit organization specifically related to activities undertaken to solicit and manage donations. These expenses are typically reported separately in the Statement of Functional Expenses.

Examples of fundraising expenses include:

1. Event Costs: If the nonprofit hosts galas, charity runs, auctions, or other fundraising events, the associated costs (such as venue rental, catering, and promotional materials) would fall under this category.
2. Salaries and Benefits: The compensation and benefits for fundraising staff, including those who plan events, write grant proposals, manage donor relationships, or carry out other fundraising tasks.
3. Marketing and Advertising: Costs associated with promoting the organization and its fundraising events, such as print and digital advertising, direct mail campaigns, and public relations efforts.
4. Professional Services: Fees related to hiring consultants or agencies specialized in fundraising strategies, grant writing, or donor management.
5. Donor Recognition: Costs associated with acknowledging donors, such as producing plaques, certificates, or gifts, or hosting appreciation events.

Fundraising expenses are necessary for nonprofits to attract the resources they need to fulfill their mission. However, these organizations need to keep these costs in proportion to their overall budget to ensure most of their funds are directed toward program services. Donors often look at the ratio of fundraising expenses to total expenses to gauge the efficiency of a nonprofit.

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How to Prepare a Statement of Functional Expenses

Preparing a Statement of Functional Expenses involves categorizing and reporting all costs incurred by a nonprofit organization according to their functional classification: Program Services, Management and General Expenses, and Fundraising Expenses. 

Start by identifying all the expenses related to carrying out the mission of the organization, which fall under Program Services. 

Next, list all the costs associated with the overall administration and management of the nonprofit under Management and General Expenses. 

Lastly, account for all the costs associated with fundraising activities. It’s crucial to maintain accurate and detailed records of all expenses to ensure precise reporting. The statement should provide a clear picture of how the organization is utilizing its resources, which can help stakeholders assess its efficiency and effectiveness.

Gathering Necessary Information

Gathering necessary information is a crucial step in any decision-making process, project planning, or report preparation. Here’s a general overview of how to approach it.

Data Collection

Data collection and organization are two integral steps in any research process, decision-making, or project planning. Here’s a brief overview of how to approach them:

1. Identify your Needs: Understand what information you need. This could be specific data points, expert opinions, best practices, or historical data.
2. Define Sources: Identify where this information can be obtained. This could include internal records, online research, industry reports, interviews with experts, or customer surveys.
3. Collect Data: Gather the information from the identified sources. This could involve downloading reports, conducting interviews, or compiling data from various sources.
4. Organize Information: Systematically arrange the collected data for easy access and analysis. This could involve creating spreadsheets, databases, or filing systems.
5. Verify and Validate: Check the accuracy and reliability of the information. Cross-reference facts, check the credibility of sources, and ensure the data is up-to-date.
6. Analyze and Interpret: Evaluate the data to conclude, identify trends, or make decisions. This could involve statistical analysis, trend analysis, or benchmarking.

Remember, the quality of your output often depends on the quality of the information you gather, so it’s worth investing time and effort into this process.

Data Organization

1. Data Entry: Input the collected data into a suitable format for analysis. This could be a spreadsheet, database, or specific statistical software.
2. Data Cleaning: Check the data for errors or inconsistencies and correct them. This step is crucial for maintaining the accuracy and reliability of your data.
3. Data Coding: If you’ve collected qualitative data, you might need to code it into categories for easier analysis.
4. Data Storage: Store the data securely to maintain its integrity and confidentiality. This could be on secure servers, encrypted files, or cloud-based platforms.
5. Data Arrangement: Arrange the data logically for easy access and analysis. This could involve sorting data, creating tables, or visualizing data through charts or graphs.

Remember, the quality of your analysis and conclusions heavily depends on the quality of your data collection and organization processes.

Categorizing and Classifying Nonprofit Functional Expenses

A 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 fundraising which are called support services and programs which is how much money is spent on their mission.

Remember, the key to effective expense categorization is consistency. Use the same categories each time you track your expenses to get a clear picture of your spending habits over time.

Allocating Costs to Appropriate Categories

Allocating costs to appropriate categories is a key process in accounting and financial management. This practice helps to understand the cost structure of a business, make informed decisions, set pricing strategies, and prepare financial statements. Here’s a general guide on how to allocate costs:

1. Direct Costs: These are costs that can be directly attributed to a specific product, service, or department. Examples include raw materials used in production, direct labor costs, and shipping costs for a specific product. These costs should be allocated directly to the respective products or departments.
2. Indirect Costs: These costs support the overall operation of the business and cannot be tied directly to a specific product or department. Examples include rent, utilities, administrative salaries, and office supplies. Indirect costs should be allocated based on a reasonable and consistent method.
   Common methods include:
   • Square footage: If you’re allocating rent or utilities, you might divide these costs based on the square footage occupied by each department.
   • Time spent: If you’re allocating administrative salaries, you might divide these costs based on the time spent supporting each department or project.
   • Use of resources: If you’re allocating costs like IT support or machinery, you might divide these costs based on the usage by each department or product.

What are the benefits of classifying functional accounting?

The process of classifying functional expenses is known as 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.
• 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, financial statements must be presented by functional area. A Certified Public Accountant (CPA) needs to qualify their opinion, stating that the statements were not prepared by generally accepted accounting principles (GAAP).

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.

Common Mistakes to Avoid when Classifying Functional Expenses

Many organizations mistakenly focus solely on the funding source when classifying their expenses, overlooking the reasons behind those expenses. However, by utilizing functional accounting effectively, it becomes possible to classify all three elements – who, why, and what – with the appropriate account number segments in your chart of accounts. 

Every transaction, whether coming into or going out of the organization, should be identified with an account code. To ensure comprehensive categorization, the account code must correspond to the: who, what and why. 

• Who: Funding Source
• What: The Revenue or Expense category
• Why: The Functional Area

Misclassifying Expenses

Misclassifying expenses is a common mistake in financial accounting that can have serious implications. This typically happens when an expense is recorded under the wrong category or account in the general ledger or financial statements.

To avoid misclassification, it’s important to understand the 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.

Tips for Accurate Classification

Here are some key tips for accurate transaction classification in accounting:

1. Understand basic accounting principles.
2. Use a detailed chart of accounts.
3. Maintain consistent record keeping.
4. Regularly review and reconcile your transactions.
5. Utilize accounting software to reduce human errors.
6. Train your staff adequately on transaction classification.
7. Consult with professionals when in doubt.
8. Keep abreast of changes in tax laws and accounting standards.
9. Document your accounting processes.
10. Keep business and personal finances separate.

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Bottom Line

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.

Want to read more? Check out these insightful articles:

• Nonprofit Accounting: Best Practices for Preparing Financial Statements
• Nonprofit Funds and Programs: How to Categorize in Accounting
• Statement of Activities: How to Read This Key Nonprofit Financial Report
• Nonprofit Support Services: Impact On Bottom Line
• Funding Nonprofit Overhead for Functional Expenses

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