Nonprofit GAAP Guide: Reporting Expenses by Function vs. Nature

If you were to make a personal budget, you’d probably divide your expenses based on what they are: car payments, groceries, Netflix subscription, etc.

But what if you had to divide your expenses based on what they do?

For the past few years, the IRS has required nonprofits to do just that. While for-profit companies report costs based on their nature alone (what they are), nonprofits must report expenses on IRS Form 990 based on their nature and function: what they are and what they do.

In this article, we compare natural vs. functional expenses, explain how to allocate costs – and hopefully make filing your next 990 a little easier.

Hold On. Why Should I Care?

Creditors, grantors, donors, watchdog groups – they all rely on the information on your Form 990 to understand how your nonprofit spends its money. If you want to build trust, you need to give them an accurate, complete, and clear picture of your expenses.

It’s also important because, well, it’s the law. The IRS requires that you report both functional and natural expenses on your Form 990. (Most organizations file their Statement of Functional Expenses as a separate document within their 990, but you can also include it within the Statement of Activities or in the Notes to the Financial Statements.) Failure to file can jeopardize your tax-exempt status.

Finally, the Generally Accepted Accounting Principles (GAAP) require a statement of functional expenses, so you’ll need one to pass an audit.

The bottom line? Completely and accurately reporting your expenses is essential. And it starts with understanding how to categorize them.

Natural vs. Functional Expenses

There are two main ways to categorize your expenses: naturally and functionally. To file a proper 990, you’ll need to understand both.

Reporting Natural Expenses is the most, well, natural way of looking at your costs. This method categorizes expenses based on what they are: rent, utilities, salaries, marketing, etc. Your rent is one line item. So is your recent marketing campaign. It’s pretty intuitive.

You can also categorize those very same costs as Functional Expenses.

This method requires a bit more calculation. When reporting functional expenses, you’ll categorize each line item according to its purpose, whether that’s directly supporting your mission, raising funds, or covering the management and administration of your organization.

Let’s dig deeper into those three categories.

The 3 Types of Functional Expenses

Every functional expense falls into one (or more) of three categories:

  1. Program Services
    This covers any costs associated with executing your mission. That could include program administrator salaries, as well as certain supplies, portions of your rent, and other expenses.While smaller organizations may have a single, clearly defined program service, larger organizations often have multiple classes of services. They will need to create sub-categories within their Program Services and organize their expenses accordingly.For example, if my autism services organization provides clinical support for children and at-home care for adults, I will need to divide my program expenses into two groups – one for clinical services, another for adult care – and label them accordingly.
  1. Fundraising and Membership Development
    This includes expenses related to raising money and developing members, ranging from marketing and staff salaries to fundraising event costs, expenses related to creating grant proposals, etc.
  1. Management and Administration
    This third category is a catch-all, encompassing overhead costs that aren’t directly related to executing your mission or raising funds. Portions of office rent, executive salaries, and certain supplies may all be covered here.

Pictured below is a sample analysis. Designing your analysis along these lines is a good place to start.

It may sound straightforward. But what happens when an expense doesn’t neatly fall into one of these three categories?

Allocating Functional Expenses

While certain functional expenses may belong in a single category, many will serve multiple purposes.

For the latter, the bookkeeper must divide the item’s total cost across multiple categories according to their relative weight.

For example, let’s say one of your staff members performs several functions. You calculate that they spend 70% of their time on mission-related work, 20% on non-mission administrative services, and 10% on writing grant proposals and participating in other fundraising activities.

In that case, you would divide the cost of their salary based on how they spend their time: 70% on programming, 20% on administration, and 10% on fundraising.

Determining how to properly allocate funds can be difficult and ambiguous. That’s why it’s so important to have clear, detailed reporting procedures – and to follow them consistently.

Why Good Reporting Procedures Matter

Good reporting procedures are important because they help bookkeepers allocate functional expenses appropriately, accurately, and consistently.

They’re also required by regulators. The Financial Accounting Standards Board (FASB) requires that organizations establish clear processes and procedures for allocating expenses and apply them consistently. Generally Accepted Accounting Principles (GAAP) also state that organizations must disclose these processes and procedures in their Form 990.

Another good way to ensure complete and accurate reporting? Outsource it to a team you trust.

Outsource Your Accounting for Consistency, Clarity and Confidence

Want to spend less time worrying about bookkeeping and compliance and more time focused on your mission?

Dugan + Lopatka, CPAs can modernize, streamline and augment your financial management. Our experienced CPAs deliver everything from accurate bookkeeping and timely reports to in-depth guidance and strategic planning.

And with Outsourced Accounting from D+L, you get all the services you need in a flexible, affordable solution that scales with your organization.

Learn more about our decades of experience with nonprofit clients or connect with D+L here.

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