For nonprofit finance leaders, few reporting requirements cause as much confusion as functional expense allocation. Donors, grantors, and board members all scrutinize how your nonprofit organization spends its resources—and your statement of functional expenses tells that story.
The challenge? FASB's nonprofit accounting standards have evolved significantly, and many not-for-profit entities struggle to maintain audit-ready records that satisfy both compliance requirements and stakeholder expectations. This nonprofit guide breaks down what functional expenses are, how to allocate functional expenses properly, and what the latest standards mean for your expense reporting.
What are functional expenses for nonprofits?
Functional expenses represent how nonprofits categorize and report their spending based on the purpose of each cost. Unlike for-profit businesses that simply track actual expenses by type (salaries, rent, utilities), nonprofit organizations must also show why those costs were incurred.
This functional expense classification system exists because nonprofits have a unique accountability obligation. Your donors want to know their contributions fund your mission. Grantors need assurance that restricted funds are used as intended. And regulators require transparency about how tax-exempt organizations operate.
The statement of functional expenses provides this transparency by organizing all costs into three functional categories:
- Program services: Costs directly supporting your mission and programs, often called program expenses
- Management and general (M&G): Administrative overhead including finance, HR, and oversight functions
- Fundraising: Fundraising expenses associated with soliciting contributions and membership dues
Functional expense categories vs. natural expense categories
Understanding the distinction between functional and natural expense categories is essential for accurate nonprofit financial reporting.
Natural expenses describe what you spent money on—the nature of the expense itself. Natural categories include salary costs, rent, utilities, depreciation, and professional fees. These natural expense categories appear on a standard income statement.
Functional expenses describe why you spent the money—the purpose or function it served. The same salary expense might be split across program services (a case manager), management and general (your accountant), and fundraising (your development director).
Your nonprofit statement of functional expenses presents both natural and functional classifications together, typically as a matrix showing natural classification in rows and functional categories in columns. This format helps financial statement users understand both what resources your organization consumed and how those resources advanced your mission.
What is a statement of functional expenses?
The statement of functional expenses is one of the core financial statements nonprofits must prepare. It presents your organization's total expenses broken down by both function (program, M&G, fundraising) and nature (salary, rent, supplies, etc.).
Under the Financial Accounting Standards Board (FASB) guidelines and generally accepted accounting principles (GAAP), nonprofits can present this information in one of three ways:
- As a separate statement of functional expenses
- Within the statement of activities
- In the financial statement notes
Regardless of presentation method, the information must show expenses by function and by natural classification. Most audited nonprofits present a separate statement of functional expenses because it provides the clearest view for donors and grantors reviewing your financial statements. Many organizations also reference a statement of functional expenses template to ensure proper formatting alongside the statement of financial position and statement of cash flows.
FASB ASU 2016-14: Key changes to functional expense reporting
The Financial Accounting Standards Board issued Accounting Standards Update (ASU) 2016-14 to improve nonprofit financial reporting and provide greater transparency for financial statement users. This update, part of the accounting standards codification, represented the most significant change to nonprofit accounting standards since the mid-1990s.
The most impactful change involves how organizations must classify management and general expenses. Previously, FASB didn't explicitly define what belongs in M&G. Nonprofits used descriptions for program service, fundraising, and membership development—then placed remaining expenses in M&G.
Now, FASB requires specific functions to remain in management and general and prohibits allocating them to other categories:
- General record keeping and payroll—includes finance (CFO, accounting), grant accountants, billing, accounts receivable, payroll processing, and audit costs
- Employee benefits management and oversight (Human Resources)
- Budgeting departments and functions
- Oversight functions and business management
- Soliciting funds other than contributions and membership dues, including:
- Promoting the sale of goods or services to customers, including advertising costs
- Responding to government, foundation, and other requests for proposals for customer-sponsored contracts
- Administering government, foundation, and similar customer-sponsored contracts—including billing, collecting fees, and grant and contract financial reporting
- Disseminating information about stewardship of contributed funds
- Announcing appointments and producing the annual report
How to allocate functional expenses for your nonprofit organization
Functional expense allocation requires a consistent, documented methodology for allocating shared costs across program, M&G, and fundraising categories. The goal is creating audit-ready records that accurately reflect how your nonprofit organization uses its resources to report functional expenses properly.
Direct allocation method
Some expenses clearly belong to a single functional area. A program manager's salary goes entirely to program services. Your development director's compensation is 100% fundraising expenses. These direct allocation assignments are straightforward and require minimal documentation.
Shared cost allocation
Most expense allocation challenges involve shared expenses—costs that benefit multiple functions. Common examples include:
- Rent and utilities: Allocate expenses based on square footage used by each function. If your program staff occupies 70% of your office space, 70% of rent becomes a program expense.
- Shared staff salary costs: When employees work across functions, allocate based on documented time. A CFO who spends 80% of time on finance (M&G) and 20% supervising program staff can allocate 20% to program services—but only with proper documentation.
- Technology and equipment: Allocate based on usage patterns or headcount by functional area.
Documentation requirements for expense allocation
Your methodology for allocating expenses must be reasonable and auditable. While FASB doesn't prescribe specific documentation methods, most auditors expect:
- Time tracking: Staff timesheets that capture hours by function provide the strongest support for salary allocations
- Time studies: Periodic assessments of how staff divide their time across functions
- Job descriptions: Documentation supporting why certain roles allocate time to specific functions
- Allocation policies: Written procedures explaining your organization's methodology for allocating functional expenses
Form 990 and functional expense report requirements
Your statement of functional expenses directly impacts your Form 990 filing—the annual return most tax-exempt organizations must file with the IRS. Part IX of Form 990 requires reporting total expenses and functional expenses broken down by program services, management and general, and fundraising.
Consistency between your audited financial statements and IRS 990 is critical. Significant discrepancies raise red flags for regulators and can trigger questions from grantors conducting due diligence.
Many donors and watchdog organizations use 990 data to calculate program expense ratios—the percentage of total expenses going to program services versus overhead. While the "33% rule" suggesting nonprofits should spend at least 33% on programs is an oversimplification, stakeholders do scrutinize these ratios when reviewing your functional expense report.
What this means for your program expense ratio and net assets
The FASB changes have real implications for how your nonprofit organization appears to donors and grantors. Many nonprofits previously allocated portions of finance, HR, and budgeting costs to program activities. Under current standards, these must remain in management and general.
This means many nonprofit organizations will report higher M&G expenses and lower program expense percentages than before—even with no change in actual expenses or net assets.
If you're concerned about donor perception:
- Communicate proactively: Explain the accounting standards change in your annual report and donor communications
- Focus on outcomes: Shift donor attention from expense ratios to mission impact
- Document thoroughly: Ensure every allocation decision can withstand audit scrutiny
Best practices for functional expense allocation
Strong functional expense reporting starts with reliable data collection. Organizations that track time and expenses accurately throughout the year face far less stress during audit preparation than those scrambling to reconstruct allocations after the fact.
Establish clear policies: Document your allocation methodology before you need to defend it. Include the rationale for each allocation basis (square footage, time, headcount) and get board approval.
Invest in time tracking: For salary allocations—often your largest expense category—accurate time data eliminates guesswork. When staff can document hours by program, project, or grant, your allocations become defensible.
Review allocations quarterly: Don't wait until year-end to catch problems. Regular reviews help identify changes in how staff spend time or how space is utilized.
Coordinate with your auditor: Discuss significant allocation changes before implementing them. Your auditor can flag potential issues and help you document your methodology appropriately.
Common mistakes in functional expense classification
Even experienced nonprofit finance teams make allocation errors when they classify and report functional expenses. Watch for these common pitfalls:
- Inconsistent methodology: Changing allocation methods year-over-year without justification raises auditor concerns
- Undocumented allocations: "We've always done it this way" isn't sufficient support for an audit
- Overallocating to programs: The pressure to show strong program ratios can lead to aggressive allocations that don't withstand scrutiny
- Ignoring the M&G requirements: Finance, HR, and oversight functions must stay in management and general under current standards
- Forgetting Form 990 alignment: Your IRS 990 filing should match your audited financial statements
How time tracking supports internal functional expense allocation
For organizations where salary represents a significant expense category, time tracking provides the foundation for defensible allocations. Without reliable time data, you're left estimating—and estimates often don't survive audit scrutiny when you need to report functional expenses.
Consider a CFO at a smaller nonprofit who handles both finance and direct program oversight. Under FASB standards, all finance activities must remain in M&G. But time spent directly conducting or supervising program services can be allocated to programs—provided you can document it.
That documentation might include:
- A job description explaining why the CFO has program responsibilities
- Timesheets or time studies showing hours spent on each functional area
- Consistent allocation percentages supported by actual time data
Organizations using purpose-built time tracking for grant compliance often find the same data serves their functional expense allocation needs. The time you invest in accurate tracking pays dividends across multiple reporting requirements.
