Wednesday, July 19, 2023
Financial ReportingAccounting BasicsFor Executive DirectorsFor Nonprofit Accountants
Accountability is at the core of nonprofit accounting. While for-profit organizations leverage accounting practices to maximize their profits, nonprofits like yours record and report on their finances to demonstrate that the funds donors and stakeholders contribute are being reinvested into the organization in order to further its mission.
A key component of this accountability-focused approach to accounting is compiling financial statements, which are documents that summarize your nonprofit’s use of funds. In addition to helping you draw actionable conclusions from financial data, these statements are required for your organization to comply with the Generally Accepted Accounting Principles (GAAP), as well as state and federal regulations for nonprofits.
The statement of functional expenses is one of the financial statements fundamental to nonprofit accounting. In this guide, we’ll cover the basics of this report, including:
- What is the nonprofit statement of functional expenses?
- Categories of Functional Expenses for Nonprofits
- Purpose of the Statement of Functional Expenses
- Nonprofit Statement of Functional Expenses Template
Let’s get started with an overview of the statement of functional expenses and how it fits into your nonprofit’s financial management practices.
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What is the nonprofit statement of functional expenses?
The nonprofit statement of functional expenses is a table- or matrix-style report that breaks down your organization’s expenditures into categories based on what purpose the money was used to accomplish. Typically, the three categories of functional expenses are program, administrative, and fundraising expenses (which will be covered in more detail later).
The statement of functional expenses is one of four financial reports that your nonprofit should compile annually. The other three statements are the:
- Statement of activities, which categorizes your nonprofit’s revenue and expenses to give an overview of your organization’s transactions for a given year.
- Statement of financial position, which provides a snapshot of your nonprofit’s financial health by breaking down your assets and liabilities.
- Statement of cash flows, which shows how money moves in and out of your organization through operating, investing, and financing activities.
While each of these reports has a direct for-profit parallel—the income statement, balance sheet, and cash flow statement respectively—the statement of functional expenses is unique to nonprofits. Some businesses compile a statement of costs of goods sold, which is somewhat similar in purpose to a nonprofit’s functional expense report. However, the for-profit version typically only includes costs related to production, not management or selling.
The statement of functional expenses is a much more comprehensive breakdown of your nonprofit’s expenditures. Here is an example of what the report might look like:
In this sample statement, the columns of the table represent the three categories of functional expenses. The categories represented by the rows are often referred to as natural expenses, which organize expenditures based on the nature of the payment rather than its end goal. Additionally, this is often how transactions are recorded in your accounting system as they occur.
Categories of Functional Expenses for Nonprofits
If your nonprofit records expenditures based on natural categories, why do you need to report on your functional expenses? There are two main reasons. First, most state and federal documents that your organization has to file to maintain its 501(c)(3) status ask that you categorize expenses by function rather than nature. Second, functional categories promote transparency by showing how much of your funding is spent on mission-related activities and how much is used to run the organization.
With that in mind, here is a breakdown of the three categories of functional expenses:
- Program expenses are directly related to your organization’s work to make a difference in your community. The nature of these expenditures varies widely among nonprofits depending on their missions. For example, an animal shelter would include the costs of veterinary care supplies and pet food under its program expenses, while an organization that provided free after-school tutoring would include the cost of books and school supplies for participating students.
- Administrative expenses are sometimes also called “management and general expenses,” but both terms refer to the costs of operating your nonprofit day to day. Office equipment, rent, utilities, property insurance, and staff compensation are a few of the administrative expenses your organization may incur.
- Fundraising expenses are the costs associated with launching initiatives to generate revenue for your organization. These may involve investing in fundraising software solutions, creating marketing materials, planning events, and paying fees to fundraising consultants.
The term “overhead expenses” is often used in the context of budgeting, which for nonprofits refers to the administrative and fundraising categories of functional expenses combined. You may also have heard of the 65/35 rule, which states that at least 65% of nonprofits’ spending should go toward program expenses and overhead expenses should comprise 35% or less of the total:
In reality, this breakdown will look different for every nonprofit. As you review your organization’s statement of functional expenses, don’t worry if it doesn’t exactly follow the 65/35 rule. Instead, focus on finding ways to put more funding toward programming and reducing unnecessary administrative or fundraising costs.
Purpose of the Statement of Functional Expenses
Analyzing each nonprofit financial statement provides unique insights into your organization’s financial situation and allows you to make data-driven decisions about how to manage funding. As we alluded to in the previous section, a major area of decision-making that the statement of functional expenses informs is the creation of your nonprofit’s annual operating budget. By comparing the report with your predictions from the previous year, you can make more accurate projections when allocating expenses for the coming year.
The main practical purpose of the statement of functional expenses is to assist in filing your nonprofit’s annual tax return. Your organization may be required to complete a statement of functional expenses depending on which version of the IRS Form 990 you file:
- The full Form 990 includes a statement of functional expenses as one section of the 12-page document. If your nonprofit’s annual gross receipts exceed $200,000 or your total assets are greater than $500,000, filling out this report is essential for your organization to maintain its tax-exempt status.
- Forms 990-N, 990-EZ, and 990-PF (designed for small shops, midsize nonprofits, and private foundations respectively) don’t ask for a full functional expense report. However, the 990-EZ and 990-PF versions require different, abbreviated expenditure reports, and your statement of functional expenses can guide you in completing that section. Additionally, check your state’s requirements to determine if your nonprofit needs to submit any financial statements separately to your state government.
In addition to these direct purposes, the indirect benefit that the statement of functional expenses provides is increased transparency with donors and other stakeholders in your organization. Whether the statement automatically becomes publicly available with the rest of your Form 990 or you choose to include it in your annual report, communicating your functional expenses demonstrates how your organization uses its funding to further its mission. This helps donors trust that you’ll handle their contributions appropriately, encouraging them to continue supporting you.
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Nonprofit Statement of Functional Expenses Template
Each organization’s statement of functional expenses will look slightly different depending on what natural expenses they incur and how resources are allocated. However, the functional expense categories of program, administrative, and fundraising costs are consistent for all nonprofits.
Here is a basic template to help you get started with compiling your nonprofit’s statement of functional expenses:
Because the details of this report are highly dependent on your organization’s unique financial situation, pulling it together can be challenging. The best way to ensure your statement of functional expenses meets reporting requirements and accurately represents your nonprofit’s spending is to work with a nonprofit accountant.
An accountant has the expertise to compile your statement of functional expenses, analyze the data it contains, and determine next steps that will allow your organization to manage its finances more effectively. Your organization can save time, energy, and money by outsourcing these tasks to an accounting firm that specializes in working with nonprofits, like Jitasa.
Wrapping Up
Your nonprofit’s statement of functional expenses is vital to an effective financial management strategy. While its main purpose is to ensure compliance with federal and state regulations, analyzing it and applying the insights you glean to your expense allocation and budgeting provides even more value for your organization. As you organize your expenditures into the categories of program, administrative, and fundraising spending, don’t hesitate to reach out to a nonprofit accountant who can answer your questions and help you make the most of this report.
If you’d like to learn more about the statement of functional expenses and related nonprofit accounting topics, check out these resources:
- Establishing a Nonprofit Chart of Accounts [+ Example]. Your statement of functional expenses is based on data stored in your chart of accounts. Learn more about this resource in our complete guide.
- Nonprofit Form 990 Filing: An Essential Tax Guide. Dive deeper into the process of filing your nonprofit’s annual federal tax return and how your statement of functional expenses can support your efforts.
- Bookkeeping and Accounting Services Exclusively for Nonprofits. Discover what working with an outsourced accountant looks like and explore Jitasa’s services, which are tailored to nonprofits’ needs.
Work with the accounting experts at Jitasa to compile and analyze your nonprofit statement of functional expenses.
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