What Are Functional Expenses? A Guide to Nonprofit Accounting

If you don’t see a code for the activity you are trying to categorize, select the appropriate code from the NAICS website at 2022 NAICS Census Chart. Select the most specific 6-digit code available that describes the activity producing the income. Avoid using codes that describe the organization rather than the income-producing activity.

• The functional areas included in the statement of functional expenses typically include programs, fundraising, and management and administration.
• The Statement of Functional Expenses that nonprofits issue is referred to as a matrix, because it requires organizations to report their expenses by both functional and natural classification.
• Every organization’s ideal ratio actually differs based on size, age, and mission.
• Even though the information on policies and procedures requested in Section B generally isn’t required under the Code, the IRS considers such policies and procedures to generally improve tax compliance.

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• A diversion of assets can in some cases be inurement of the organization’s net earnings.
• The Statement of Functional Expenses helps achieve this by detailing how much of the organization’s resources are directed towards achieving its mission through direct program activities versus how much is spent on administrative and fundraising functions.
• And the balance (17,000 sqft) is used as classroom space to execute your programs.
• Because Z received less than $100,000 reportable compensation for the calendar year ending with or within Y’s tax year from Y and its related organizations, Y isn’t required to report Z as a former key employee on Y’s Form 990, Part VII, Section A, for Y’s tax year.
• D is also a partner in an accounting firm with 300 partners (with a 1/300 interest in the firm’s profits and capital) but isn’t an officer, director, or trustee of the accounting firm.

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Fundraising expenses

Examples of natural expenses include salaries, rent, utilities, supplies, and travel. This classification provides a straightforward view of what types of costs the organization incurs. Avoid using broad categories such as “program expense” when creating natural classifications. That’s a functional label and is too vague to meet the definition of natural classification. Track and allocate program expenses across multiple charitable activities, administrative costs, and fundraising efforts for nonprofit organizations.

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If the related organization was related to the filing organization for only a portion of the tax year, Debt to Asset Ratio then the filing organization may choose to report only compensation paid or accrued by the related organization during the time it was actually related. A “current” officer, director, or trustee is a person that was an officer, director, or trustee at any time during the organization’s tax year. A “current” key employee or highest compensated employee is a person who was an employee at any time during the calendar year ending with or within the organization’s tax year, and was a key employee or highest compensated employee for such calendar year. For certain kinds of employees and for retirees, the amount in box 5 of Form W-2 can be zero or less than the amount in box 1 of Form W-2.

• Jo-Anne is a certified Sage Intacct Accounting and Implementation Specialist, a certified QuickBooks ProAdvisor, an AICPA Not-for-Profit Certificate II holder, and Standard for Excellence Licensed Consultant.
• Specifically, the detailed roadmap actively shows how the organization allocates its funds.
• Understanding how to properly prepare a statement of functional expenses doesn’t just show you how money was spent.
• It must then report the corresponding liability (the amounts to be paid to the creditors on the debtors’ behalf) on line 21.
• It helps leadership understand the full costs of each function, which aids in strategic decision-making and budgeting.

The statement of functional expenses is considered an ancillary report that can be added to the primary set of financial statements. Thus, it is not necessary (unless demanded by a recipient of the financial statements), but can contain useful information. Following these requirements also enables you to provide transparency to contributors and regulators about how you used resources to achieve your organization’s mission. The statement of functional expenses, in terms of dollars and cents, shows what was accomplished (programs) and how (management and general and fundraising). Nonprofits report these activities in a separate statement known as the “statement of functional expenses.” While only some nonprofits are required to provide a statement of functional expenses, like voluntary health and welfare organizations, all nonprofits are strongly encouraged to do so.

Ensure that the statement follows recognized nonprofit accounting standards to facilitate clarity and compliance. Identify and allocate shared or indirect expenses across the different functional categories using reasonable allocation methods. This ensures that overhead costs are fairly distributed, giving stakeholders a more accurate view of each function’s spending.

Document Procedures For the Allocation of Nonprofit Functional Expenses

An organization must provide a written disclosure statement to donors who make a quid pro quo contribution in excess of $75 (section 6115). This requirement is separate from the written substantiation acknowledgment a donor needs for deductibility purposes. While, in certain circumstances, an organization may be able to meet both requirements with the same written document, an organization must be careful to satisfy the section 6115 written disclosure statement requirement in a timely manner because of the penalties involved. For each fundraising event, the organization must keep records to show the portion of any payment received from patrons that isn’t deductible, that is, the retail value of the goods or services received by the patrons. If certain excise, income, statement of functional expenses social security, and Medicare taxes that must be collected or withheld aren’t collected or withheld, or these taxes aren’t paid to the IRS, the trust fund recovery penalty can apply. The trust fund recovery penalty can be imposed on all persons (including volunteers) who the IRS determines were responsible for collecting, accounting for, and paying over these taxes, and who acted willfully in not doing so.

If an employee is a key employee of the organization for only a portion of the year, that person’s entire compensation for the calendar year ending with or within the organization’s tax year, from both the filing organization and related organizations, should be reported in Part VII, Section A. Part VI requests information regarding an organization’s governing body and management, governance policies, and disclosure practices. Although federal tax law generally doesn’t mandate particular management structures, operational policies, or administrative practices, every organization is required to answer each question in Part VI. For example, all organizations must answer lines 11a and 11b, which ask about the organization’s process, if any, it uses to review Form 990, even though the governing body isn’t required by federal tax law to review Form 990.

Reviewing and Updating Allocation Bases

Don’t include on line 6a rental income related to the filing organization’s exempt function (program service). For example, an exempt organization whose exempt purpose is to provide low-rental housing to persons with low income would report that rental income as program service revenue on line 2. On lines 1a through 1f, report cash and noncash amounts received as voluntary contributions, gifts, grants, or other similar amounts from the general public, governmental units, foundations, and other exempt organizations.