The statement of functional expense also referred to by some as a “SOFE”, provides the reader of the financial statement more detail of an entity’s expenses. The SOFE shows the expenses broken down by an expense’s purpose. This statement classifies expenses by its natural expense classification and also its functional expense classification. The natural expense classification breaks down expenses “according to the economic benefits received in incurring those expenses”, such as professional fees or office supplies. The functional expense classification allocates expenses by its “purpose for which the expense is incurred.” This method breaks down expenses by program and supporting services. Program service expenses are associated with carrying out a nonprofit’s services. Supporting services are not directly related to a nonprofit’s services. Common supporting services seen on a statement of functional expenses include management expenses and fundraising expenses. Fundraising expenses are used to account for all costs of the entity to solicit contributions. These expenses may be both direct and indirect.
Expenses that are related to one or more of an entity’s programs or services should be allocated to as many programs as the expense is related to. These expenses are commonly allocated on the basis of square footage (occupancy costs), employee time records (salaries), and asset usage (depreciation). It is important that an organization determines a method of expense allocation that aligns most closely with the purpose of actual expenses. As a best practice, an entity should periodically evaluate employee time allocated to various programs, what space and supplies should be allocated to each program, and so on. This allocation should be evaluated each year and adjusted to be reasonable for any changes in the entity.
As a reminder, all nonprofits need to present expenses by their functional and natural classifications. This is most commonly done through a SOFE (as part of the financial statements), but entities may choose to present the expense breakdown on the statement of activities or in the notes of its financials.