Allocating expenses by function is often one of the most significant estimates included in a nonprofit organization’s financial statements. The process determines how costs are divided among program services, management and general activities, fundraising, and, when applicable, membership development.
These classifications affect more than the presentation of the financial statements. Donors, grantors, board members, regulators, and charity evaluators may use functional expense information to understand how an organization deploys its resources.
Under current accounting standards, all nonprofit entities must present expenses by both natural classification and functional category. This information may appear in a separate statement of functional expenses, on the face of another financial statement, or within the financial statement notes.
Because the financial statements belong to the nonprofit organization, management is responsible for developing a reasonable allocation methodology. Auditors may evaluate the methodology and test the resulting amounts, but they should not be expected to create the organization’s expense allocations.
Understanding the requirements, configuring the general ledger appropriately, and documenting the rationale behind each allocation can make year-end reporting more accurate and the audit process more efficient.
Understanding Functional Expense Reporting
FASB ASC 958-720-45 requires nonprofit organizations to provide information about expenses by functional classification.
Functional categories describe the purpose for which expenses were incurred. The primary classifications include:
Program Activities
Program expenses relate directly to the activities that fulfill the organization’s mission.
Depending on the nonprofit, these costs may include expenses associated with education, healthcare, community programs, research, advocacy, housing assistance, religious activities, or other mission-based services.
Management and General Activities
Management and general expenses support the overall administration and operation of the organization rather than a particular program or fundraising activity.
Examples may include:
- Accounting and finance functions
- Board governance
- General legal services
- Human resources administration
- Organization-wide planning
- Executive oversight not directly connected to a program
- General office administration
Not every activity performed by executive or administrative personnel automatically belongs in management and general. The classification should reflect the actual nature of the work performed.
Fundraising Activities
Fundraising expenses include costs incurred to encourage donors, foundations, corporations, and other parties to provide financial support.
These costs may include fundraising campaigns, donor communications, special events, grant development, direct mail, and compensation for employees who perform fundraising activities.
Membership Development Activities
Some organizations may also report membership development as a separate supporting activity.
This category may include efforts to recruit prospective members, retain existing members, and maintain relationships when those activities do not directly qualify as program services or fundraising.
Why Functional Expense Allocations Matter
Many nonprofit expenses can be assigned directly to a functional category. For example, supplies purchased exclusively for a specific program can generally be recorded directly as a program expense.
Other expenses benefit several parts of the organization and require allocation. These may include:
- Salaries and employee benefits
- Rent and utilities
- Information technology
- Insurance
- Software subscriptions
- Equipment leases
- Office supplies
- Shared administrative services
The allocation of these costs requires judgment. Even when an organization uses a reasonable method, the resulting amounts remain accounting estimates that should be supported by reliable information.
An unsupported or outdated methodology can distort the organization’s financial story. It may overstate or understate program costs, create inconsistencies between reporting periods, and lead to questions from auditors, funders, or board members.
Management Owns the Allocation Methodology
Nonprofit leaders sometimes assume that functional expense allocation is primarily an audit matter. However, management is responsible for preparing the financial statements and establishing the underlying accounting estimates.
The CFO, controller, finance director, or other responsible employee is usually in the best position to understand how the organization operates.
For example, an executive director at a smaller nonprofit may spend substantial time delivering programs, meeting with donors, and overseeing administration. Their compensation should be allocated based on those actual activities rather than automatically classified entirely as management and general.
Similarly, an employee with an administrative title may spend meaningful time supporting a particular program. Job titles alone do not determine functional classification.
Auditors can review the methodology, assess whether it is reasonable, and test the supporting information. Management, however, should develop and approve the methodology based on the organization’s actual operations.
Using General Ledger Software to Support Allocations
A properly configured general ledger can significantly simplify functional expense reporting.
Many modern accounting platforms, including QuickBooks Online and other nonprofit accounting systems, allow organizations to track several dimensions within a transaction. These may include:
- Natural account
- Program
- Department
- Project
- Funding source
- Restriction classification
- Grant
- Location
- Functional category
The goal is to capture as much relevant information as reasonably possible when a transaction is initially recorded. Directly assigning expenses during normal processing reduces the number of costs that must be allocated manually at year-end.
Understand the Software’s Capabilities
Before implementing or upgrading an accounting system, finance personnel should understand which tracking fields are available and how they affect reporting.
The organization should determine whether the software can produce reports showing expenses by both natural classification and functional category.
A system may technically support several dimensions, but the setup will only be effective when employees use the fields consistently.
Evaluate Current Operations
A system conversion is an opportunity to reconsider the chart of accounts and reporting structure.
Rather than automatically recreating the old setup, management should evaluate:
- How many programs and departments currently operate
- Whether employees work across multiple functions
- Whether the organization uses time sheets
- How restricted grants are tracked
- What information managers and the board need
- Which reports are required by funders
- How functional expenses are currently calculated
Treating the conversion as a fresh design process can produce a more useful and sustainable accounting structure.
Identify Indirect and Organization-Wide Costs
Some costs cannot be assigned to a single function when they are initially recorded. These costs may benefit the entire organization or several departments.
Finance personnel may group these amounts into an indirect cost category and allocate them periodically using an established method.
Separating indirect costs makes the allocation process easier to understand and allows management to review the total amount being distributed.
Plan the Historical Data Conversion
Organizations changing accounting systems should also decide how much historical data to import.
Comparative financial information for at least the prior fiscal year is generally useful. However, transferring every historical transaction can be expensive, time-consuming, and vulnerable to errors.
One practical approach is to import month-end balances for the 12 months before the conversion. This may provide sufficient comparative information for the statements of financial position, activities, changes in net assets, and functional expenses.
Use Available Implementation Support
Accounting system conversions can affect financial reporting, payroll, grant tracking, internal controls, and audit support.
Organizations should use the implementation resources offered by the software provider and involve appropriate internal personnel. Outside accounting advisors may also help evaluate the chart of accounts and reporting design.
Improving an Existing Chart of Accounts
A complete system conversion is not always necessary.
An organization may be able to improve functional expense reporting by updating its existing chart of accounts, adding tracking fields, or developing a clear mapping process.
For example, the organization might retain its current natural expense accounts while adding program, department, and functional classifications to each transaction.
The chart of accounts should support the organization’s allocation methodology rather than make it more difficult. An overly complex structure may result in inconsistent coding, while a structure that is too simple may not capture the information needed for accurate reporting.
The appropriate level of detail depends on the size and complexity of the organization.
Common Functional Expense Allocation Methods
Costs that cannot be directly assigned should be allocated using a reasonable and consistently applied method. The selected basis should reflect how the underlying resource is used.
Square Footage
Square footage or space utilization may be appropriate for:
- Rent
- Utilities
- Building insurance
- Repairs and maintenance
- Depreciation on facilities
- Other occupancy costs
For example, if a program occupies 60 percent of the organization’s usable space, allocating 60 percent of certain facility costs to that program may be reasonable.
The calculation should account for shared areas when necessary.
Time and Effort
Employee time is commonly used to allocate:
- Salaries
- Payroll taxes
- Health insurance
- Retirement contributions
- Other employee benefits
Time sheets, activity reports, calendars, or periodic time studies may support the allocation.
Organizations receiving federal funding should pay particular attention to timekeeping requirements. When employees work on multiple programs, awards, or functions, a reliable timekeeping system may be essential.
Headcount
Employee headcount may be a reasonable basis for shared administrative costs such as:
- Human resources support
- Information technology services
- Copier or printer leases
- General employee training
- Certain office services
This method may be appropriate when the benefit of a service is closely connected to the number of employees in each department or function.
Usage
Usage-based methods may be appropriate for:
- Software licenses
- Equipment
- Program materials
- Printing
- Telephone services
- Technology platforms
For example, the cost of a software platform may be allocated based on the number of licenses assigned to each department.
Other Reasonable Measures
Some costs may require a different allocation basis. Organizations should select a method that reflects the nature of the expense and how the organization receives the benefit.
Relevant guidance and examples can be found in FASB ASC 958-720-55-25 through 55-31.
Documenting the Allocation Methodology
A written functional expense allocation policy is one of the most important supporting documents a nonprofit can maintain.
The documentation should explain:
- Which expenses are directly assigned
- Which expenses are allocated
- The allocation basis used for each expense category
- The source of the underlying data
- How frequently allocations are recorded
- Who reviews and approves the calculations
- How changes in operations are evaluated
- How estimates are updated
For example, a policy might state that facility costs are allocated annually based on occupied square footage, while salaries and related benefits are allocated monthly using employee time records.
Documentation helps the auditor understand management’s rationale and improves consistency when employees leave or responsibilities change.
Review the Methodology Annually
An allocation approach that was reasonable several years ago may no longer reflect the organization’s activities.
Nonprofits may add programs, expand facilities, change staffing structures, adopt remote work arrangements, or shift fundraising responsibilities. Each of these developments can affect expense allocations.
Management should review the methodology at least annually and ask:
- Do the allocation bases still reflect actual usage?
- Have employee responsibilities changed?
- Are time records complete and reliable?
- Have new programs or departments been added?
- Are shared spaces being used differently?
- Are the selected methods applied consistently?
- Does the general ledger provide sufficient support?
Any changes should be documented, approved, and applied consistently.
Preparing for the Audit
Auditors will generally evaluate whether the organization’s functional expense allocations are reasonable and supported.
Management should be prepared to provide:
- The written allocation policy
- Current organizational charts
- Employee time records
- Salary allocation schedules
- Square footage calculations
- Headcount reports
- General ledger detail
- Reconciliation schedules
- Evidence of management review
- Explanations for changes from the prior year
Significant or unusual changes in allocation percentages may require additional explanation.
Preparing these materials before the audit begins can reduce delays and help management respond confidently to questions.
Final Thoughts
Functional expense reporting is more than a year-end compliance exercise. It communicates how a nonprofit uses its resources and supports the broader story presented in its financial statements.
Finance leaders are in the best position to develop an allocation methodology that reflects the organization’s actual programs, personnel, facilities, and shared services. Accounting software and a well-designed chart of accounts can make the process more efficient, but technology cannot replace management judgment.
The most effective approach is to directly assign costs whenever possible, allocate shared costs using reasonable methods, document the rationale, and review the methodology each year.
Auditors should evaluate the organization’s approach, not create it. The nonprofit should own its functional expense story and provide auditors with a clear, supportable basis for reviewing it.
