What is the Statement of Functional Expenses?
The statement of functional expenses (SOFE) is a financial report used by not-for-profit organizations to present the functional classification of expenses in addition to the natural classifications of expenses. Natural expense classifications are what constitutes an organization’s chart of accounts and what is featured on its statement of activities. Examples of these include salaries and wages, rent, utilities, insurance, repairs and maintenance, and supplies. Functional expense classification further classifies natural expenses into three areas: program, management and general, and fundraising.
Program expenses represent costs related to the operations of an organization’s programs, which are aimed at fulfilling the organization’s mission. Because of this, the majority (75% is a good benchmark) of an organization’s expenses should show up in this category.
Management and general expenses are considered supporting expenses and are associated with running an organization, regardless of its mission. Common natural expenses in this category are accounting, legal, financing fees, license and filing fees.
Fundraising expenses are also supporting expenses and consist of costs incurred in raising funds for the organization. Natural expenses in this category could be related to fundraising events, mailers, and employees’ time spent fundraising.
Why is it important?
FASB issued ASU 2016-14, Presentation of Financial Statements for Not-for-Profit Entities (effective for fiscal years beginning after December 15, 2017), which requires all nonprofit organizations to present expenses by natural classification and functional classification. This can be done on the face of the statement of activities in the notes to the financials or as a separate statement (SOFE). In addition to this, not-for-profit organizations exempt under 501©(3) and 501©(4) need to report expenses by natural and functional expense classification on IRS Form 990.
Aside from accounting regulations that require a SOFE in some form, it’s a useful tool for the organization to visualize how their resources are being used. As mentioned previously, most of an organization’s expenses should be devoted to its programs, since those are what will help the organization work towards its mission. If a not-for-profit’s SOFE is showing this isn’t the case, it’s a good starting point for a discussion on why this may be.
Functional Expense Allocation
For natural expenses that can’t be directly tied to one or multiple programs or to one of the support services categories (management and general, and fundraising), a functional expense allocation needs to be done. It will spread the natural expense among the programs and supporting services it indirectly relates to. Examples of natural expenses that are often allocated are personnel costs, rent, utilities, insurance, and supplies. There are a few acceptable allocation methods to choose from: square footage, headcount, and time studies.
The allocation method should be chosen based on what makes sense for the organization. For example, a small organization that doesn’t have departments and whose employees perform a variety of functions probably wouldn’t want to use a headcount method to allocate functional expenses. A time study allocation would be more effective for its allocation.