The Statement of Functional Expenses, or SFE, is a section of the IRS Form 990, the annual tax return required from all 501(c)3 non-profits. The SFE requires us to fully report an organization’s expenses for a tax year in terms of three categories:
- Program service expenses
- Management and general expenses
- Fundraising expenses
The IRS defines these categories as follows:
Program services are mainly those activities that further the organization’s exempt purposes. Fundraising expenses should not be reported as program-service expenses even though one of the organization’s purposes is to solicit contributions. Include lobbying expenses in this column if the lobbying is directly related to the organization’s exempt purposes (. . .) Also include costs to secure a “grant,” or contract, to conduct research, produce an item, or perform a program service, if the activities are conducted to meet the grantor’s or other contracting party’s specific needs.
Management and general expenses relate to the organization’s overall operations and management, rather than to fundraising activities or program services. Overall management usually includes the salaries and expenses of the organization’s chief executive officer and his or her staff, unless a part of their time is spent directly supervising program services or fundraising activities ( . . . ) Lobbying expenses should be reported in this column if they do not directly relate to the organization’s exempt purposes. Organizations must also report the following [as Management and general]: costs of board of directors’ meetings; committee meetings, and staff meetings (unless they involve specific program services or fundraising activities); general legal services; accounting (including patient accounting and billing); general liability insurance; office management; auditing, human resources, and other centralized services; preparation, publication, and distribution of an annual report; and management of investments.
Fundraising expenses are the expenses incurred in soliciting cash and noncash contributions, gifts, and grants. Report as fundraising expenses all expenses, including allocable overhead costs, incurred in: (a) publicizing and conducting fundraising campaigns and (b) soliciting bequests and grants from individuals, foundations, other organizations, or governmental units ( . . . ) This includes expenses incurred in participating in federated fundraising campaigns; preparing and distributing fundraising manuals, instructions, and other materials; and preparing to solicit or receive contributions.
In Xero, we use a Tracking Category called Department to allocate expenses to one of these three categories. (This is called Class in QuickBooks). Each category becomes a department, and income and expense is coded to one of these three departments. Organizations commonly use sub-departments of Program to track their program spending in greater detail. Note also that Management and General is commonly shortened to Management (as in these help articles) or referred to as Administration instead. Fundraising is also commonly referred to as Development.
The IRS also distinguishes between Direct and Indirect expenses:
Direct costs are expenses that can be identified specifically with an organization’s activity or project, and can be assigned to an activity or project with a high degree of accuracy. Indirect costs are costs that cannot be identified specifically with an activity or project.
We use a fourth department to cover Indirect costs, called Shared or Shared Expenses. A common example of a Shared expense is office rent. Organizations typically work on Program, Management, and Fundraising efforts in the same office, so the rent cannot be booked as a direct cost.
The expenses booked to Shared are ultimately moved into the other three departments (Program, Management and Fundraising) by a process called a Shared Allocation. This is part of closing an accounting period. When the period is fully closed, Shared expense is zero, and all expense is allocated as either Program, Management, or Fundraising. This allows the organization to fully report its expense in the three categories used in the SFE.
For more information on Shared Allocations, see Shared Allocation.
Definitions from irs.gov Instructions for Form 990