At some point a board member is going to ask how much of each dollar actually reaches your programs. Grant applications want the same number, and plenty of donors check it before they give.
If your books only show what you spent money on, and not why, that question gets hard to answer fast.
That's the job of a statement of functional expenses. It shows every expense by type and by purpose, so anyone reading your financials can see exactly where the money went.
This post covers what the statement is, who has to prepare one, and how to build it. There's a full worked example partway down, with the math behind every split.
A statement of functional expenses is a nonprofit financial report that breaks down total expenses two ways: by natural classification (what you spent money on, like salaries or rent) and by functional classification (why you spent it: programs, management and general, or fundraising).
It's one of the core nonprofit financial statements, and it usually looks like a grid. Expense types run down the side, and functions run across the top.
The three functions are:
Add the three columns together, and you get your total expenses. That total should match the expenses on your statement of activities.
Natural expenses describe what you bought. Functional expenses describe the purpose behind it. One natural expense often splits across more than one function.
Natural expenses answer the question "What did we spend money on?" They come straight from your chart of accounts: salaries, rent, insurance, supplies, and so on.
Functional expenses answer "Why did we spend it?" They come from your allocation method, and they always land in one of three buckets: program services, management and general, or fundraising.
Your executive director's salary is the classic example. In the chart of accounts, it's a single line under salaries and wages. Allocate it by function and that one line can spread across all three columns, because most EDs run programs, oversee the office, and spend time with donors in the same week.
Is a statement of functional expenses required? For most U.S. nonprofits, yes, in some form. If your financial statements follow GAAP, you must show expenses by both nature and function. If you're a 501(c)(3) or 501(c)(4) filing the full Form 990, you report functional expenses on Part IX too.
Even if you're small enough to skip both, the three-way split is worth tracking. Grant applications and board reports tend to ask for it anyway.
Under FASB's ASU 2016-14, nonprofits must present an analysis of expenses by both natural and functional classification in one location. As the Journal of Accountancy explains, that analysis can sit on the face of the statement of activities, in a separate statement, or in the notes.
That update, which reshaped not-for-profit (NFP) financial statements, took effect for calendar year 2018 and fiscal year 2019 year ends. It also requires a note disclosure explaining how you allocate costs among functions, so your method needs to be written down.
Many organizations choose a separate statement because it's the easiest format for boards and funders to read. If your organization goes through a nonprofit audit, your auditor will expect to see this analysis.
Part IX of Form 990 is the IRS version of the statement of functional expenses. The form is direct about it: section 501(c)(3) and 501(c)(4) organizations must complete all columns, which means program service, management and general, and fundraising expenses. Other exempt organizations only report totals.
Part IX also uses its own set of expense lines, like occupancy, information technology, and insurance, so you may need to map your accounts to its categories.
You generally file the full Form 990 if your gross receipts are $200,000 or more, or your total assets are $500,000 or more, according to the IRS instructions. Smaller organizations may be able to file Form 990-EZ instead.
Learn more about common Form 990 mistakes.
Below is a simplified example for a fictional youth literacy nonprofit with $450,000 in annual expenses. Use the layout as a basic statement of functional expenses template: expense types down the side, functions across the top.
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Here's how each cost was split:
About 64% of this nonprofit's spending goes to programs, about 18% to management and general, and about 18% to fundraising.
That's a clear story for a board or a grant reviewer. For context, the BBB Wise Giving Alliance's charity standards call for spending at least 65% of total expenses on programs. This example lands just under that mark.
Landing a point short is a reason to talk with your board about staffing and space, and maybe about where the organization is headed next. Shuffling costs between columns to look better on paper is a different thing, and a bad habit to start. Whatever the split turns out to be, it has to rest on allocations you can explain and back up with records.
Not sure how your shared costs should be split on your books?
Complete Balance Accounting & Consulting helps nonprofits set up clean, audit-ready books that track expenses by function all year, so the numbers are ready when a funder or auditor asks.
To prepare a statement of functional expenses, start with expenses recorded by natural account in your books. Assign every direct cost to its function. Then allocate the shared costs using a method you can defend, and check that the column totals tie back to your statement of activities.
The natural side is already covered by your chart of accounts. The functional side takes one extra habit. Every time a transaction is recorded, tag it with a function. Many nonprofits that run QuickBooks do this with classes, one for each function, and add sub-classes under Program Services when they run more than one program. Run a Profit and Loss by Class report and you have the functional view.
If you already use fund accounting, your function tags work alongside your fund tracking. This guide to QuickBooks for nonprofits covers the setup in more detail.
Plenty of costs belong to one function and nothing else. Books for a tutoring program are a program cost. The audit fee is management and general. The deposit on a gala venue is fundraising, and so is the printing for the invitations.
Code those straight to their function when the bill comes in. What's left is a much shorter list of truly shared costs, and that's all you need to allocate.
Shared costs need an allocation base, meaning a measurable reason for the split that reflects how each cost is actually used. Some common bases:
Whatever base you land on, there should be a record behind it. Time sheets, or a floor plan with the square footage marked up. If the only reason for a split is that it looked about right, expect your auditor to push back on it.
Get the method on paper, even if it's only a one-page memo that names the base for each shared cost and gives a short reason for it. After that, the goal is to leave it alone. A move to a bigger space, or a new program that changes how staff spend their days, is a fair reason to revisit it. Most years, nothing that big happens.
This is also the method you'll describe in the notes to your financial statements. Keep it steady and your year-over-year comparisons mean something. Audit season tends to go easier too.
Before the statement reaches your board or auditor, check that each column adds up, that the total matches your statement of activities, and that the split makes sense for how your organization really operates.
An experienced nonprofit accountant can catch allocation problems before a funder or auditor does.
These are the errors that most often make a statement of functional expenses look off to the people reading it:
Learn more about common nonprofit accounting mistakes.
Because it's the report your funders actually read. Grant reviewers often check the program column against total expenses early on, and your board treasurer looks there too. Internally, the same split tells you which costs crept up this year, useful once next year's budget is on the table.
Program expenses are costs that directly carry out your mission. That includes staff who deliver services, supplies used in programs, and the share of rent and utilities for program space. Costs for running the office, accounting, or raising money belong in management and general or fundraising instead.
Not always. Your financial statements follow GAAP, while Part IX of Form 990 follows IRS rules, so GAAP vs. tax basis differences are normal. Keep a simple reconciliation between the two, so you can explain any gaps to your board, auditor, or tax preparer when questions come up.
One common difference is investment fees. Under GAAP, investment expenses are netted against investment return and left out of the functional expense analysis. Form 990 reports them as an expense on Part IX, line 11f.
Yes. Many nonprofits use QuickBooks classes to tag each expense with a function, then run a profit and loss report by class. You'll still need to allocate shared costs, like salaries and rent, using a documented method. A clean class setup makes the whole process much faster.
The literacy nonprofit in the example came in at 64% program spending. On its own, that figure tells a grant reviewer very little. What they'll want, and what your auditor will ask for, is the time records and square footage math behind it. A statement of functional expenses is only as good as the allocations under it, so sort those out while there's still time to fix a weak one.
If you're not sure your books track expenses by function the right way, now is a good time to review them. Reach out to our team to see how we can help clean up your reporting and give you more confidence in your numbers.
👉 Want a quick gut check first? Grab our free 20-Point Nonprofit Financial Health Checklist, or learn more about our nonprofit accounting services.
