When it comes to reporting expenses, the biggest difference between nonprofit organizations and for-profit businesses is that nonprofits use functional accounting to classify expenses.
Importance of Functional Accounting for Nonprofit Organizations
One of the major differences in financial statement presentation between for profit companies and nonprofit organizations is the presentation of expenses on the Statement of Activities and Changes to Net Assets. While the revenue section of the report is the same as a standard income statement, with a list of revenue by category, such as contributions and gifts, program service revenue, grants and investment income, the expense section does not list expenses by category, but by functional classification.
A nonprofit exists to perform specific services and programs, as stated in their mission. The purpose of functional accounting is to present the nonprofit organization’s major types of activities, primarily program or mission-based services and supporting services such as administration, governance and fundraising. Breaking down expenses by functional area reflects the broad outlines of major nonprofit reporting requirements as outlined in SFAS-117 and for filing the IRS Form 990, which requires nonprofits to divide expenses by program, management and general and fundraising.
Functional Accounting Required for Annual Audits
For any organization that undergoes an annual audit, their financial statements must be presented by functional area, or the CPA will be required to qualify their opinion, stating the statements were not prepared in accordance with generally accepted accounting principles.
Besides the regulatory requirements of reporting by functional area, the most important reason to report on functional expenses is it is an ideal method for tracking the real costs of program and supporting activities, making it an invaluable tool for decision-making. It allows you to see exactly what each of your individual programs is costing, whether your fundraising is proportionate to the areas that need it, and whether a specific program is sustainable.
As a subsidiary report to your financial statements, the Statement of Functional Expenses is a detailed list of the nature of each expense (salaries, payroll taxes, rent, professional services) by functional area. This report is necessary also when comparing actual expenses to budgets in each of your functional areas.
Functional accounting allows you to identify three elements of each expense.
- Who is paying for the expense, i.e. a specific grant, donor.
- What the expense is for such as payroll, rent or supplies.
- Why was the expense incurred for programs, or support services.
Common mistakes nonprofits make when classifying expenses
A lot of organizations mistakenly classify their expenses only on the who element, by focusing on the funding source rather than the why the expense was incurred. But, if used properly, functional accounting can classify all three elements of the who, why and what with appropriate account number segments in your chart of accounts. Each transaction coming into or going out of the organization should be identified with an account code corresponding to the funding source (who), the revenue or expense category (what) and the functional area (why) of that transaction.
By integrating these elements into your accounting system, the easier it will be to generate more accurate and relevant financial statements both internally and externally. This will make it easier to report on each of your organization’s programs and determine which programs are running efficiently and effectively. A detailed functional report will provide management with the information needed to make more informed decisions on your organization’s financial health.
If your current accounting system cannot generate functional reports by program and support services, and by funding source, then you should consider evaluating your present system and investing in an upgrade of your financial software such as FastFund Accounting.
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