Functional Accounting

Functional accounting is a method of accounting that is based on the organization’s major types of activities, primarily (a) program or mission-based services and (b) supporting services such as administration, governance and fund development.

Functional accounting allows you to identify three key characteristics of every dollar coming into and going out of the organization:

Breaking down expenses by what and why reflects the broad outlines of major nonprofit reporting requirements. For example, the IRS Form 990 asks nonprofits to divide expenses by program, management/general and fundraising. A statement of functional expenses is required as part of the audit for voluntary health and welfare organizations.

But a statement of functional expenses is also recommended for every organization for three reasons. First, unless your organization is very small (less than $25,000 in revenue annually), you probably have to file a 990 or 990-EZ already. Second, even if you are very small now, you might someday be large enough to need an audit – so you might as well get in the habit of creating a statement of functional expenses right now.

Third, and perhaps more importantly, a statement of functional expenses is an ideal method for tracking the real costs of program and supporting activities, making it an invaluable tool for decision-making. It allows you to see exactly what Program X is costing, what Program Y is costing, whether your fundraising is proportionate to the areas that need it, whether you want to build, maintain or scale back a program and so forth.

The information found in a statement of functional expenses can most easily be organized, streamlined and accessed through the meeting of two basic functional accounting tools: your chart of accounts and your functional areas.

Chart of Accounts

A chart of accounts consists of numbered account names that describe the types of income and expenses that your organization experiences over time. It is the list of categories that tracks the what of each dollar coming into and going out of your organization.

Your chart of accounts should be flexible enough to change as your organization changes. For example, you want to be able to insert new income and expense categories as they arise. But you want to be able to insert them within the broader categories of the existing chart instead of simply appending them to the end of it, which is why it is numbered by the tens, hundreds and thousands instead of 1, 2, 3 and so on.

Functional Areas

Functional areas place the who and the what of each dollar into the why – the program or service for which that dollar is designated. Many organizations that I have worked with tend to track the why by funder or contract rather than by mission-based purpose. But if you use Functional Accounting, you can use functional areas to cross-cut funder information with programs/services and income or expense line items so you can accurately track any given dollar in its journey through your organization. If you haven’t already developed functional areas, start with your mission. Read your goals and values statements, and take a look at how your nonprofit is divided programmatically. Identify each larger purpose, within the overall organization, on which you spend time and money.

Each transaction coming into or going out of the organization should be identified with a code corresponding to the who, the what and the why of that transaction. The more you can integrate these three pieces, the higher-quality, more accurate reports you will produce. And you will produce them more quickly. If your accounting system cannot slice and dice your numbers these three ways, you might consider an upgrade of your financial software.  Don’t forget also to integrate those three questions – who, what and why – into all your relevant processes such as payment requisition forms and record-keeping for bills that come in. It can take some time to set up, but once it is set up, tracking and reporting runs very smoothly. And it will make your auditor happy, too.

Statement of Functional Expenses: Breaks out the nonprofit's expenses by program, administration and fundraising.

Categories of expense delineated by the type of expense: program services, management & general, and fundraising. Required for IRS form 990 and audited financial statements. Often reflect the use of allocations.

Chart of accounts (COA) is a list of the accounts including a unique number of each allowing to locate it in each ledger. The list is typically arranged in the order of the customary appearance of accounts in the financial statements. A chart of accounts can track a specific financial information. Each account in the chart has assigned a unique identifier, typically an account number. Each account in the Anglo-Saxon chart is classified into one of the five categories: asset, liability, equity, revenue, and expense. Separation of individual accounts by several numerical places allows multiple new accounts to be placed between existing ones.

Expenses: costs you incur in the course of doing your work (payroll, rent, office expenses, etc.).

Revenue: what you earn (grants, contracts and donations, sales or rental income).

Income earned from services performed or merchandise sold (as distinct from support, or contributed income).

Income: what you earn (grants, contracts and donations, sales or rental income).

The general definition of an audit is an evaluation of a person, organization, system, process, project or product. Audits are performed to ascertain the validity and reliability of information; also to provide an assessment of a system's internal control. The goal of an audit is to express an opinion on the person / organization/system (etc) in question, under evaluation based on work done on a test basis. Due to practical constraints, an audit seeks to provide only reasonable assurance that the statements are free from material error. Hence, statistical sampling is often adopted in audits. In the case of financial audits, a set of financial statements are said to be true and fair when they are free of material misstatements - a concept influenced by both quantitative and qualitative factors.