Functional Expense Reporting (By Nature and Function)

4.5 Functional Expense Reporting (By Nature and Function)

Functional expense reporting is a cornerstone of financial disclosure for nongovernmental not-for-profit organizations. Under U.S. GAAP, specifically FASB ASC 958‑205, not-for-profit entities are required to present expenses by both their natural classifications (e.g., salaries, occupancy, office supplies) and their functional classifications (e.g., program services vs. supporting services). This requirement ensures that stakeholders such as donors, grantors, regulators, and the general public can better evaluate how resources are used to fulfill an organization’s mission.

This section explores the foundational concepts behind functional expense reporting, covering the regulatory requirements, best practices for classifying expenses, recommended presentation formats (including matrix presentations), and practical case studies. By understanding both the “what” (nature) and the “why” (function) of expenses, readers gain deeper insights into a not-for-profit’s operational and strategic priorities.

Importance of Functional Expense Reporting

Functional expense reporting highlights how an organization allocates its resources to achieve its mission. It accomplishes the following:

• Enhances transparency: By disclosing operating expenses in detail, external and internal stakeholders obtain a clear view of where the organization’s money is spent—whether on mission-critical tasks or general oversight.
• Facilitates accountability: Regulators, donors, and the public can hold an organization accountable by assessing the efficiency of its resource allocation.
• Improves comparability: Standardized presentation by nature and function helps stakeholders compare the spending patterns and mission-focus of similar not-for-profits.

Overview of Requirements Under GAAP

FASB’s Accounting Standards Codification (ASC) Topic 958 guides not-for-profit entities. According to ASC 958‑205, not-for-profit entities must provide:

• A qualitative description of the methods used to allocate expenses among program and support functions.
• A presentation of expenses by their function and by their natural classification in one of the following places:
– On the face of the Statement of Activities (less common because of overcrowding).
– In a separate Statement of Functional Expenses (often favored by many organizations for clarity).
– In the notes to the financial statements (if an entity chooses not to present it on the face of the Statement of Activities or in a dedicated statement).

A key takeaway is that expenses must be broken down into at least two functional categories—program and supporting services. Supporting services typically include “Management and General” (often referred to as M&G) and “Fundraising.”

Distinguishing Between Nature and Function

Functional reporting is a two-dimensional approach:

1. By Nature
   Expenses by nature show the “type” of expense incurred, such as:
   • Salaries and wages
   • Employee benefits and payroll taxes
   • Rent or occupancy costs
   • Utilities
   • Depreciation or amortization
   • Office supplies and postage
   • Professional fees (legal, accounting, consulting)
   • Information technology
   • Marketing and advertising

2. By Function
   Functional classifications explain the “purpose” for which the expenses were incurred:
   • Program Services (activities that result in goods or services being distributed to beneficiaries, customers, or members to fulfill the mission)
   • Supporting Services:
   – Management and General (M&G): Overseeing and administering the organization as a whole, including executive oversight, financial management, human resources, and governance.
   – Fundraising: Costs incurred to raise funds from donors or grantors, including campaign development, promotional events, and donor relations.

Matrix Presentation: The Common Approach

A not-for-profit organization often uses a matrix format to fulfill the requirement of reporting expenses by both nature and function. This matrix typically includes rows for each natural classification (e.g., salaries, rent, supplies) and columns for functional classifications (e.g., program services, management and general, and fundraising). The totals by category are then provided.

Below is a simplified illustration of a possible matrix for functional expense reporting:

Each line item (natural classification) is allocated across the three main functional categories (program, management and general, and fundraising). The final column sums up the total for each natural line item, providing a comprehensive view of how the not-for-profit’s resources have been consumed.

How to Allocate Expenses

Some expenses are “direct” since they are easily attributed to a single function, such as a fundraising gala expense going solely under fundraising, or a program staff member’s salary going under program services. Other expenses are “indirect,” meaning they need to be allocated among multiple functional categories. Examples include rent, IT infrastructure, depreciation, and certain shared staff salaries.

Allocation methods vary depending on the type of expense. For instance:
• Rent/Occupancy Costs: Allocated based on square footage usage, staff headcount in functional areas, or other rational measure.
• Salaries: Allocated based on timekeeping systems, time studies, or management estimates of staff time spent on each function.
• Utilities: Allocated similarly to occupancy based on space usage or general usage patterns.

Entities should disclose their allocation methodology either in the notes to the financial statements or in the statement of functional expenses. This transparency allows readers to understand how management divided expense items among various functions.

Regulatory Guidance and Best Practices

1. FASB ASC 958‑205 Requirements
   • Emphasizes that functional expense reporting is mandatory.
   • Encourages detailed, consistent allocation methods.
   • Requires disclosures of how the organization’s overhead or indirect costs are assigned among program and supporting services.

2. Consistency in Allocation
   • Applying the same method for each period helps ensure comparability over time.
   • When methodology changes occur, not-for-profits should disclose the reason and the financial impact of those changes.

3. Adequate Documentation
   • Maintain time records or cost studies for any department or staff whose work supports more than one function.
   • Document assumptions used to distribute overhead, enabling auditors to verify the reasonableness of the allocation.

4. Monitoring by the Board and Management
   • Board members should review functional expense reports for reasonableness and alignment with strategic goals.
   • Management can use functional expense data to identify inefficiencies or areas needing more resources.

Flow of Classification (Mermaid Diagram)

Below is a simple flowchart illustrating how an expense originates, is classified by its nature (type), and ultimately is allocated among various functions.

    flowchart LR
	    A(Identify Expense) --> B{Nature of Expense? <br/> (Salaries, Rent, etc.)}
	    B --> C{Direct or Indirect?}
	    C --> D[Directly trace to <br/> one function]
	    C --> E[Allocate to multiple <br/> functions based on usage]
	    D --> F(Assign to Program <br/> or Support)
	    E --> F(Assign to Program <br/> or Support)
	    F --> G(Completed Matrix)

Explanation of Diagram Flow: • First, the expense is identified (A).
• Next, its nature is categorized (B).
• The organization determines whether that expense is directly associated with a single function or if it is indirect (C).
• Direct expenses flow straight (D) to a single function.
• Indirect expenses require an allocation methodology (E).
• Finally, these assigned costs are consolidated into a functional expense presentation (F and G).

Program Services vs. Supporting Services in Detail

To prepare a robust functional expense report, not-for-profit organizations need in-depth clarity on what qualifies as program services vs. supporting services:

• Program Services:
– Direct project costs (e.g., educational materials for a training program).
– Staff salaries dedicated to service delivery.
– Travel expenses for staff visiting program sites or beneficiaries.

• Management & General:
– Salaries of executives who oversee the entire organization (CEO, CFO, etc.).
– General office operations (e.g., HR, accounting, IT support not specific to a program).
– Board governance expenses.

• Fundraising:
– Costs associated with solicitation, donor events, and marketing to raise funds.
– Donor relationship management software and mail campaigns.
– External fundraising consultants or specialized marketing firms.

Common Pitfalls and Challenges

1. Over-Allocation to Program Services:
   Some organizations may be tempted to inflate the program portion of expenses. This can compromise the integrity of the financial statements and lead to regulatory scrutiny.

2. Under-Reporting of Fundraising Expenses:
   Fundraising costs are often substantial. Understating them by lumping them into program expenses or M&G can mislead donors.

3. Unclear Allocation Methodology:
   Using vague or inconsistent allocation methods complicates an auditor’s review and can lead to noncompliance with GAAP if material misstatements occur.

4. Lack of Proper Documentation:
   Failing to keep records of allocation assumptions (especially for salary allocations) can make it difficult to substantiate your reporting choices.

Case Study: Community Health Outreach (CHO)

Imagine a not-for-profit named “Community Health Outreach (CHO)” dedicated to providing medical relief in underserved regions. CHO has three main programs:

• Mobile clinics providing free check-ups.
• Health education outreach in public schools.
• A telehealth platform for remote consultations.

CHO also engages in typical supporting services. Let’s see how CHO might classify a few major expenses:

• Salaries:
– $200,000 for five nurses who only work in mobile clinics: Directly assigned to Program Services – Mobile Clinics.
– $150,000 for administrative staff (HR, finance, etc.): Allocated to M&G.
– $100,000 for two individuals who split their time 50/50 between telehealth services and fundraising: Allocated 50% to Program Services – Telehealth and 50% to Fundraising.

• Occupancy (Rent, Utilities, Cleaning):
CHO’s building has 70% of its floorspace dedicated to telehealth staff and administrative offices, while 30% is for training initiatives. Because the telehealth staff includes program staff and some administrative staff, CHO might further subdivide the 70% portion to attribute a portion to M&G and the rest to Program Services – Telehealth. The 30% for training is clearly programmatic.

• Purchased Services (Accounting, IT, Website Maintenance):
– Accounting fees for monthly general ledger oversight: M&G.
– IT costs for telehealth app infrastructure: Program Services – Telehealth.
– IT costs that maintain donation processing platforms: Fundraising.

In CHO’s final Statement of Functional Expenses, each of these items is placed in the appropriate row (nature) and column (function). Clear footnotes explain the rationales for each allocation.

Practical Tips to Improve Accuracy

• Implement Time Tracking: For staff who perform multiple functions, a timesheet-based system or a systematic “time study” can significantly improve accuracy.
• Adopt Reasonable Allocation Drivers: Align cost drivers (e.g., square footage, staff headcount, hours of service) with the actual usage of resources.
• Use Technology Tools: Many accounting software packages have modules that facilitate expense allocations across functional categories.
• Train Staff: Educate employees on the reasons behind functional expense reporting. Proper coding of invoices and timesheets from the start reduces corrections later.

Presentation Options

Although many organizations choose a separate Statement of Functional Expenses, be aware of all presentation possibilities:

• Separate Statement of Functional Expenses:
– Most transparent option.
– Accompanied by notes explaining cost allocation methodologies.

• Combined Statement of Activities and Functional Expenses:
– Presents functional classification within the line items of revenues and expenses.
– Can be cumbersome; generally used by smaller organizations with minimal lines of expense.

• Disclosure in Footnotes:
– Usually presented in tabular form within the notes.
– Allows the Statement of Activities to remain uncluttered.

Regardless of the chosen format, clarity and transparency remain paramount. Include narratives about what each function entails, along with an explanation of the allocation methodologies.

Real-World Scenarios and Trends

• Donor Demands for Transparency: Donors and grantors frequently request detailed breakdowns of operational and administrative expenditures. A robust Statement of Functional Expenses can serve as a key marketing tool to reassure stakeholders that contributions are responsibly managed.
• Regulatory Scrutiny: Regulatory bodies, including state attorneys general, pay close attention to how not-for-profits report their expenses. Misrepresentation or intentional misclassification can lead to penalties and reputational damage.
• Performance Metrics: Some organizations calculate “program expense ratio” (program expenses ÷ total expenses). While widely used, it should be interpreted alongside mission effectiveness, quality of programming, and strategic investment in future capacity.

Recommended Readings and Further Exploration

• FASB ASC 958, “Not-for-Profit Entities” – Official guidance on financial reporting for not-for-profits.
• AICPA Audit & Accounting Guide: Not-for-Profit Entities – Contains detailed discussions and implementation examples.
• FASB ASC 958‑205 – Comprehensive guidance on presentation of financial statements.
• The Nonprofit Times – Articles discussing industry best practices and current regulatory developments.

Functional Expense Reporting (Nature vs. Function) Quiz: 10 Key Insights

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