Not for Profit Accounting Standards: Statement of Functional Expenses

Nonprofits allocate functional expenses by sorting every dollar spent into one of three categories: program services, management and general, or fundraising. Direct costs go entirely to the function that incurred them, and shared costs are divided using a documented, consistently applied basis such as time studies, full-time-equivalent headcount, or square footage. Two authorities drive this requirement: FASB Accounting Standards Update 2016-14, which applies to GAAP financial statements, and IRS Form 990 Part IX, which asks for the same functional breakdown on your annual tax filing. Because both ask the same underlying question, one well-built allocation model can satisfy both.

Why Not for Profit Accounting Standards Require Functional Reporting

FASB ASU 2016-14, Not-for-Profit Entities (Topic 958): Presentation of Financial Statements of Not-for-Profit Entities, became effective for fiscal years beginning after December 15, 2017. Before that update, only voluntary health and welfare organizations were required to present a full statement of functional expenses. ASU 2016-14 extended the obligation to every not-for-profit entity that prepares GAAP financial statements.

The standard requires two views of every expense line: its natural classification (what was purchased) and its functional classification (why it was purchased). Salaries, rent, and depreciation are natural categories. Program services, management and general, and fundraising are functional categories. Organizations can satisfy the requirement by presenting this analysis on the face of the statement of activities, in a separate statement of functional expenses, or in a note disclosure, but the information must appear somewhere in the audited financials.

Critically, ASU 2016-14 also requires a qualitative disclosure of the methods used to allocate costs among functions. That means the basis behind your numbers is now a reviewable part of the nonprofit audit engagement, not hidden in internal workpapers. Auditors read the methodology note and test whether actual practice matches it.

On the tax side, the IRS Form 990 Part IX Statement of Functional Expenses mirrors this logic. Organizations filing the full Form 990 report their expenses across three functional columns: program services (Column B), management and general (Column C), and fundraising (Column D), with the totals in Column A. Part IX lists named expense categories on lines 1 through 24, a total functional expenses line on line 25, and a joint costs line on line 26. Because both documents are public-facing, a discrepancy between the audited statements and the Form 990 raises immediate questions. Under Internal Revenue Code Section 6033(j), an organization that fails to file a required return for three consecutive years loses tax-exempt status automatically, so the functional reporting obligation sits inside a larger compliance framework with real consequences.

The Three Functions Every Expense Must Touch

Functional reporting is only as useful as the precision of the three-bucket sort. Each category carries a distinct meaning under not for profit accounting standards, and getting the boundaries right matters.

Program Services

Program services are the costs of fulfilling the mission. This includes service delivery staff, program supplies, client-facing occupancy, and any contractor whose work directly advances a stated program. For a health clinic, program costs are clinical staff salaries, medical supplies, and the exam rooms they use. For a scholarship fund, the scholarships themselves are program costs. In a healthy operating charity, this category represents the largest share of total expenses.

Management and General

Management and general (M&G) covers the costs of governing and administering the organization that are not tied to a specific program or to raising money. Board governance, accounting, the external audit fee, legal counsel, human resources, payroll processing, and general office operations all land here. FASB ASC 958-720 is explicit that certain activities, including payroll recordkeeping and administering contracts, belong in M&G even when they touch program-related staff. These costs are legitimate and necessary. The goal is not to minimize them but to classify them accurately.

Fundraising

Fundraising captures every dollar spent soliciting contributions: development staff salaries and benefits, donor communications, direct mail, event production, grant writing, and professional fundraising fees. The functional split between program and fundraising is one of the figures donors and charity watchdogs track most closely, which makes it one of the most tempting to manage. That temptation is exactly why the methodology disclosure requirement exists.

A fourth category, membership development, appears in some presentations for organizations with dues-paying memberships, but most public charities operate entirely within the three primary functions.

Direct Costs Versus Shared Costs

The first sort is the most straightforward. A direct cost belongs entirely to one function and should be coded there at the time of the transaction. A program coordinator’s salary is 100 percent program. The external audit fee is 100 percent M&G. A gala venue deposit is 100 percent fundraising. Charge these where they obviously belong and move on.

Shared costs are where the real allocation work lives. A program director who also attends leadership meetings, an office building that houses both program staff and finance, a telephone system used by everyone in the organization: these costs serve multiple functions and must be divided on a rational basis. Not for profit accounting standards do not require perfect precision, which would be impossible. They require a method that is reasonable, documented, and applied the same way in every period.

Joint Activity Costs

One category of shared cost requires extra care. When a single activity combines program content with fundraising, such as a direct mail piece that both educates the public and solicits donations, not for profit accounting standards under ASC 958-720 presume the entire cost is fundraising unless the organization can demonstrate that the activity meets three specific criteria: purpose, audience, and content. When all three are met, a portion of the cost may be allocated to program or M&G. Organizations should treat this area conservatively. Inflated program ratios built on aggressive joint-cost treatment are a common audit finding.

A useful test for any disputed shared cost is to ask what the organization would stop buying if that function disappeared. If the cost would persist regardless of which function is removed, it almost certainly belongs in M&G rather than being spread across program lines. That question keeps general infrastructure classified honestly and prevents the slow creep of overhead into mission spending.

Allocation Methods That Hold Up Under Scrutiny

Neither FASB nor the IRS prescribes a single allocation formula. Both expect a method that is reasonable, consistently applied, and reviewed for relevance at least annually. ASC 958-720 provides examples and illustrations but leaves the specific driver to the organization’s judgment. In practice, several bases are widely accepted.

Time studies and timesheets. The strongest foundation for personnel costs. When employees record time by function, salaries, wages, payroll taxes, and benefits follow those percentages directly. Even a representative two-week study conducted periodically is more defensible than an estimate. For organizations where personnel is 60 to 80 percent of total expenses, getting this one right largely determines the accuracy of the whole statement.

Full-time-equivalent headcount. A practical proxy for occupancy and general overhead when detailed time data is not available for every employee. Allocate rent and utilities by the share of FTEs working in each function.

Square footage. Appropriate for occupancy, depreciation on the building, and facilities maintenance when functions occupy distinct, measurable space within a facility.

Usage or units of service. Useful for technology subscriptions, postage, or supplies that can be metered or counted by program activity.

The allocation methodology documentation should name each shared cost pool, the driver used, the source data for the driver, and the date the basis was last reviewed. That memo is what converts a defensible estimate into one that survives a fieldwork inquiry. Experienced audit and assurance professionals ask to see it early in the engagement.

Common Errors to Avoid

Several patterns appear repeatedly in audit findings and Form 990 reviews.

Allocating everything by revenue has no logical link to where effort goes and is the pattern most likely to draw questions. Allocating the executive director entirely to M&G when that person clearly delivers program services misrepresents leadership’s actual role. Burying fundraising staff salaries inside program lines distorts the fundraising ratio in the direction that most organizations find appealing, but the distortion is both detectable and reversible by a reviewer. Match the driver to the cost rather than searching for one blanket percentage to apply to dissimilar expense categories.

Why the Ratios Matter Beyond Compliance

The numbers in the statement of functional expenses do not stay on the page. Charity watchdogs, institutional grantmakers, and many major donors compute the program expense ratio, program costs divided by total expenses, and the fundraising efficiency ratio, fundraising costs divided by contributions received. A program expense ratio of 65 percent or higher is often cited as a healthy range, though appropriate benchmarks vary significantly by sector, organization size, and mission type.

Honest allocation matters more than flattering allocation. Overstating program by misclassifying overhead may produce a better-looking ratio in the short term, but it misleads stakeholders, contradicts the disclosed allocation methodology, and creates exposure if an audit or Form 990 review unwinds it. A board that understands the difference between cosmetically optimized reporting and substantively accurate reporting is better positioned to make the case for the administrative investment the organization actually needs.

There is a growing recognition in the sector that chronic underinvestment in M&G and fundraising backfires over time. Finance staff, technology systems, and donor stewardship capacity all cost money. When those costs are squeezed to produce a cleaner program ratio, the result is often weaker programs, higher staff turnover, and an infrastructure that cannot support growth. Accurate functional allocation gives a board the evidence to fund supporting functions at a sustainable level and to explain that investment to stakeholders without apology.

A Practical Workflow for Year-Round Accuracy

Build the allocation model once and use it continuously rather than assembling it under year-end deadline pressure.

Start by tagging every account in the chart of accounts with its default functional treatment. Most accounts have a clear single-function home. Charge direct costs at the time of the transaction rather than reclassifying in bulk at period close. That practice reduces the risk of error and removes the incentive to adjust the final split after the fact.

For shared cost pools, set driver percentages at the beginning of the year using the prior period as a baseline. Update them when circumstances change, such as a new program launch, a staff restructuring, or a change in leased space. Prepare a brief allocation memo at the time of each adjustment and keep it in the audit file.

At close, run the allocation, reconcile total functional expenses to total natural expenses (they must agree), and confirm that the same figures appear in both the audited statement of functional expenses and Form 990 Part IX. Consistency between those two public-facing documents is one of the clearest signals of a well-run finance function. Discrepancies between them are among the first things reviewers notice.

Review the methodology on a defined annual cadence rather than waiting for an auditor to ask. A short memo explaining each driver, tied to the actual program mix and staffing of the year just closed, shortens fieldwork and gives leadership a credible, ready answer when any stakeholder asks how the functional split was reached.

Related reading: Nonprofit Audit Requirements: Does Your Organization Need One?

Frequently Asked Questions

What does a statement of functional expenses show?

The statement of functional expenses is a financial schedule that presents every expense a nonprofit incurred during the period by both what was purchased (natural classification: salaries, rent, depreciation, supplies) and why it was purchased (functional classification: program services, management and general, fundraising). FASB ASU 2016-14 requires all not-for-profit entities preparing GAAP financial statements to present this analysis, and IRS Form 990 Part IX requires the same functional breakdown for tax-filing purposes.

Which nonprofits are required to prepare a statement of functional expenses?

Under not for profit accounting standards, all entities within the scope of FASB ASC 958, Not-for-Profit Entities, that prepare GAAP financial statements must present an analysis of expenses by both natural and functional classification. This requirement took effect for fiscal years beginning after December 15, 2017. On the tax side, Section 501(c)(3) and 501(c)(4) organizations filing the full Form 990 (not the 990-EZ or 990-N) must complete the functional columns in Part IX.

What allocation methods does FASB accept for shared costs?

FASB does not prescribe a single method. ASC 958-720 requires any method that is rational, systematic, reasonable, and consistently applied. Widely accepted bases include time studies or timesheets for personnel costs, square footage for occupancy and facilities, full-time-equivalent headcount for general overhead, and usage or transaction counts for metered items like postage and technology. The chosen methods must be disclosed in the financial statements.

How should an executive director’s salary be allocated?

If the executive director spends time directly conducting or supervising program activities, a portion of that salary and related benefits should be allocated to program services. The same applies to any staff member whose work spans more than one function. Time records or a documented time estimate are the preferred support. Placing an executive director entirely in management and general when that person clearly delivers mission activities is a common error that auditors and Form 990 reviewers are trained to flag.

Can a nonprofit allocate direct mail or public education costs to program services?

Only if the activity meets the joint cost criteria under FASB ASC 958-720. The organization must demonstrate that the activity satisfies all three tests: purpose (there is a genuine program purpose, not just fundraising), audience (the audience is targeted based on their need for the program content, not just their capacity to give), and content (the communication includes a clear call to action consistent with the program purpose). When all three criteria are met, a portion of the joint activity cost may be allocated to program or management and general rather than treated entirely as fundraising.

What are the risks of poor functional expense allocation?

Inaccurate allocation creates several categories of risk. On the financial reporting side, a methodology that does not match the disclosed basis in the notes is an audit finding. On the tax side, a Form 990 that is inconsistent with the audited financial statements draws scrutiny. Operationally, misclassified expenses distort the program ratio and the fundraising efficiency ratio that grantmakers and watchdogs use to evaluate the organization. Over time, a pattern of underreporting M&G and fundraising costs can lead to underfunding those functions, weakening the infrastructure that sustains programs.