How to Report on Functional Expenses

No one likes preparing for audits. Or doing their taxes. It’s easy to spend hours — if not days — sorting through Excel spreadsheets and analyzing business costs. If you’re a nonprofit, what matters most is achieving your mission. But you can’t achieve your mission without having accurate operational data about your business. Not only is it critical for board and donor transparency, it’s required by the Federal government.

So we’ve put together a quick guide to help you.

Why Report on Functional Expenses?


Statement of Functional Expenses is a requirement for compliance when filing Form 990 Part IX


Gain key insights into operations and performance when you report on functional expenses


Increased transparency and employee accountability when you record functional expenses

All organizations exempt from income tax must report on their total expenses. That should be fairly straightforward. But businesses with 501(c)(3) or 501(c)(4) status must also report on three additional categories: Program, Administrative, and Fundraising.

Yearly IRS Audits of Nonprofit Organizations

Thousands of nonprofit organizations are audited yearly by the IRS. Can you afford not to be compliant with the latest rules and regulations handed down by the FASB?
IRS Audits of Nonprofits (2001 - 2008)
IRS Audits of Nonprofits (2009 - 2011)

IRS Audits of Nonprofits Are Increasing

The average number of organizations audited by the IRS has increased exponentially within the last several years. Nonprofits are subject to more scrutiny than ever before.

Increase in IRS Audits of Charities since 2008

Nonprofit Statuses Revoked in 2011

How Do I Get Started Reporting on Functional Expenses?

Functional Expenses

1. Create internal controls

Internal controls are financial management rules designed to deter the misuse of funds. They also prove to the IRS and your donors that your nonprofit has a system of checks and balances to stay in compliance. Internal controls can be as simple as requiring two signatures on a check to ensuring that expenses are reasonable (i.e., within the range of recent industry norms). The National Council of Nonprofits has a wealth of information readily available to assist you.

2. Track employee time

Labor is often the single biggest expense in an organization, so its accurate allocation is critical to understanding the breakdown of expenses. Employee time tracking allows the board, the IRS, and your donors to understand the employee costs of a given program.

Time should be tracked by activity, service, or project, and signed off by a supervisor. Any changes to timesheets should be tracked, as they can be audited. Guidestar has some great overview of nonprofit time tracking.

3. Categorize expenses by function

Costs that result in the organization fulfilling its mission
Costs necessary for the operations of an organization that are not identifiable with a specific program, fundraising or membership activity
Costs that involve seeking, soliciting or securing contributions

This is where things get a touch tricky. While timesheets simplify the allocation of employee time and cost by function, other expenses — such as renting office space — require a bit more work, as certain programs may occupy a greater percentage of the office than others.

For example, if you have three programs in the office Reducing Ocean Pollution, Improving Veteran Health, and Educating Underserved Children, as well as a small administrative and fundraising team, you’ll want to allocate your rent and utilities proportionately across these groups.

Program Name Reducing Ocean Pollution Improving Veteran Health Educating Underserved Children Administrative Fundraising
Percentage of office space 15 25 40 5 15
Percentage of program allocation 15 25 40 5 15

Or, some costs — such as cell phone bill — may be split across Program, Administrative, and Fundraising. A similar methodology would be applied here:

 Executive Director Cell Phone Calls related to Programs Calls related to Administrative Calls related to Fundraising
Percentage of cell phone use 10 30 60
Percentage of functional expense 10 30 60
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