Like grapes, a nonprofit entity’s expenses are “clustered” on the organization’s financial statement. Nonprofits are required to report financial information using functional expense classification, which is a method of grouping expenses according to their purposes (e.g., program services and supporting services). By contrast, natural expense classification is based on the type of expense – such as employee benefits, rent, and supplies.

Nonprofits work with many types of financial statement users. Such groups include boards of directors, regulatory agencies, lenders, donors/contributors, the media, and charity watchdog groups. Each of these user types may have different priorities. While some users may be interested in fundraising activity costs (i.e., functional expenses), others may be more concerned about salaries and wages (i.e., natural expenses). Priorities may vary even within the same user groups. Consequently, the Financial Accounting Standards Board’s (FASB’s) new nonprofit financial reporting standard now mandates nonprofits to report both functional and natural expenses. Organizations may choose to present these expense classifications on a separate statement, in the note disclosures, or on the statement of activities.

The Sweet Varieties of Determination Methods

Some donors/contributors may select target nonprofits based on specific criteria, such as the ratio of fundraising expenses (or program expenses) to total expenses. Others may be interested in the level of in-kind support the organization is able to solicit. The conclusions that donors reach after analyzing a nonprofit entity’s functional expenses may have a significant impact on the organization’s ability to solicit contributions.

There are no specific requirements for determining functional expense classifications. Some expenses may be identified as direct expenses associated with a functional classification (i.e., the meals and the craft supplies provided for an after-school program). Other expenses may share a functional purpose, such as rent or supplies. For example, a lease on a building that provides a location for a particular program is functionally classified as a program expense. Any costs related to program administration are functionally classified as supporting services expenses.

Most nonprofits use a combination of identifying expenses by function and natural classification using one of the following allocation methods:

  • Direct allocation. This method involves assigning each expense to a functional category based on direct usage. Say, for example, a nonprofit receives a $2,000 phone bill. Each of the six members of the fundraising team has a mobile phone. Additionally, there are four in-office phones for the employees of the nonprofit’s daycare program. Thus, the cost would be allocated as follows:
    • Fundraising: $1,200
    • Program Expenses: $800
  • Indirect allocation. This method may be beneficial with expenses for which direct allocation could be too time-consuming. Indirect allocation involves using financial and non-financial information to determine an objective basis on which to categorize expenses. For instance, a nonprofit leasing a building may select square footage as an appropriate basis for allocating rent costs between program services and supporting services.

Let CRI Help Cultivate the Best Functional Expense Classification Method for Your Nonprofit

Although nonprofit organizations use various methods to determine functional expenses, presenting this data is critical for helping financial statement users understand how nonprofits manage their expenses. Please contact us if you need assistance implementing a classification method that “jams” well with your organization.