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What Nonprofits Need to Know About Functional Expenses

By: Jocelyn Diaz

The issuance and implementation of the FASB nonprofit financial presentation standard, Accounting Standards Update (ASU) 2016-14, back in 2016 resulted in changes to the presentation of GAAP-based financial statements for nonprofits. These changes were meant to provide financial statement reviewers, such as donors and lenders, with more relevant information about the status of an organization's current and future resources.

One key change brought about by this ASU relates to the presentation of a nonprofit’s expenses. Let’s take a deeper look at these changes and what they mean for nonprofits.

Defining Functional Expenses

Before ASU 2016-14, only voluntary health and welfare organizations were required to present expenses by both nature and function. All other types of organizations were only required to present natural expense classification.

Classifying expenses by function refers to identifying the purpose of the cost incurred. There are three general categories of functional expenses:

  1. Program services: The expenditures incurred to carry out a nonprofit’s mission.

  2. Fundraising: The expenditures incurred to solicit contributions and grant revenues.

  3. Management and general (M&G): The expenses incurred to maintain day-to-day operations of a nonprofit. Anything that doesn’t fit within the other two buckets are considered M&G.

These categories are then broken into the nature of the organization’s expenses. Natural classification relates to the economic benefits obtained from incurring these expenses. For example, an organization may incur travel expenses related to program services, fundraising and management activities. It could also incur promotional costs for only fundraising purposes, or it could incur printing expenses for only M&G purposes.

Accurate Allocation of Functional Expenses

As mentioned above, functional expenses are essentially an allocation of expenses by purpose. But making this allocation can be easier said than done since there is no standard methodology, and costs differ depending on a nonprofit's programs and use of resources.

The easiest way to start an allocation is by first identifying expenses incurred for a specific program or support service — they’ll be allocated directly. For instance, a food bank that incurs costs to transport food items will allocate the total transportation amount to program services.

A more extensive estimation process is required for expenses that cannot be tied back to a specific program or support service (e.g., payroll costs, depreciation, occupancy, and repairs and maintenance). The most common benchmarks to allocate these expenses are time and effort for payroll costs and square footage for occupancy costs.

Unless an organization requires its staff to keep track of their time spent on specific tasks and has their office space sectioned off by operation, management would have to allocate expenses based on estimates, which can be a very involved process if accuracy is the goal.

So, what is a realistic general allocation of functional expenses?

One common benchmark is a 65/25/10 percent split between program services, M&G and fundraising. This means $0.65 of every $1 is spent on program expenses to execute the organization’s mission while creating a robust administrative support system for day-to-day activities. Although no organization is the same, it never hurts to look at what similar nonprofits are doing for their allocations.

How to Present a Statement of Functional Expenses

Nonprofits can present their Statement of Functional Expenses within their financial statements (e.g., in the face of the statement of activities or a separate statement) or as a disclosure within the financial statement notes. Although ASU 2016-14 does not require a separate statement of functional expenses, we find it to be the most effective and precise presentation style. Regardless of the presentation chosen, the methods used to allocate costs by functional categories must be disclosed in the notes.

Additionally, all nonprofits must file an informational tax return, Form 990, made publicly available by the IRS. Form 990 includes a separate page dedicated solely to the allocation of functional expenses — yet another reason why presenting a separate statement of functional expenses in the financial statements is convenient and efficient. Form 990 is essentially a mirror of a nonprofit’s financial statements with additional disclosures.

Organizations might show their most recent Form 990 and financial statements on their websites. Donors will likely want to look at both as they decide which nonprofit to fund. The more accessible this information is to donors, the better.

Key Takeaways 

Though the implementation of ASU 2016-14 requires nonprofits to report functional expenses, which is not always an easy task, it is beneficial as it helps internal and external parties understand how your organization uses its resources.

While donors expect to see most of a nonprofit’s expenditures allocated towards program services, they might question a very aggressive program services allocation. Thus, when working on the allocation of functional expenses, an organization must have a thorough understanding of the correct methodology and processes in place. As with any other accounting-related matter, documentation to support the allocations is the key.

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Published February 6, 2024

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