Making Functional Expense Classifications for Nonprofits Useful for Public Trust

Under FASB ASC 958, nonprofits are required to classify functional expenses by category. Most nonprofits choose to do this in one of three ways:

  1. As a separate statement of functional expenses
  2. As a schedule in the notes of their financial statement
  3. Within the statement of activities itself

All nonprofit organizations should classify functional expenses according to their nature and category. Doing so, and sharing the information publicly in the annual report, helps build public trust by making all expenses transparent and easy to understand.

The following tips will help you make your nonprofit’s functional expenses classifications useful for both your organization and for building trust with the public.

Four Tips for Functional Expense Classifications

  1. Use common sense when determining the number of natural categories.

Some nonprofits seem to believe that the more natural categories they include, the better. The opposite is true: less is more. Too many categories can confuse the public and give the appearance of wastefulness.

U.S. GAAP does not specify a particular quantity of expense categories that must be included in the report of functional expenses, so it’s truly up to your organization on how many you’d like to include. Given that the expenses are often depicted in a table or on one page, too many expense categories will be hard to read and understand. Choose a level of detail that paints an accurate picture of your organization’s activities.

  1. Let your program activities tell the story.

Carefully consider which programs to disclose separately. Best practices for nonprofit financial accounting and reporting suggest disaggregating the major classes of program services to meet functional expense reporting requirements. In this way, your program’s finances can tell the story of how and why expenses are incurred.

  1. Review how employee services are classified.

Some expenses such as human resources, accounting, and other internal employee-related services should be reported as general administration and management because these activities benefited the organization as a whole. However, some nonprofits dislike linking all service-related internal positions to this category; it tends to “bloat” the amount, increasing the percent of funds allocated to overhead, which the public may perceive as inefficiencies or “too much money” spent on management needs. Review your allocations and consider how much of a given employee’s time is truly spent working for the good of the whole organization or for a particular program. If it can be clearly argued that an accountant is fully dedicated to a program line funded by a grant, for example, then their salary may be apportioned to that fund rather than general admin. There are many gray areas, so take this as a general guideline, and be thorough in your review of all your expense categories.

  1. Examine your allocation methodology.

One of the reporting requirements is that the allocation methodology is disclosed in your financial statements. Ask yourself, “Would someone looking at this expense understand our rational? Does it sound reasonable?” Because all the information and the methodology are disclosed to the public, it must meet the litmus test of both “is it reasonable” and is it “understandable.”

Clear Communication Improves Public Trust

Functional expense allocation is often tricky, and organizations tend to err on either side—too much disclosure or too little. A review of your current expense allocation and methodology and updating it to match current needs may help the public better understand how funds are spent and how your nonprofit handles its finances.

Welter Consulting

Welter Consulting bridges people and technology together for effective solutions for nonprofit organizations. We offer software and services that can help you with your accounting needs. Please contact Welter Consulting at 206-605-3113 for more information.