How to classify expenses by function or by nature in the income statement

Graziano Stefanelli
Sep 15
7 min read

The way expenses are classified and presented in the income statement deeply influences the financial narrative a company conveys to its stakeholders. Both IFRS (IAS 1) and US GAAP recognize the importance of expense classification in painting an accurate picture of operational performance, cost structure, and managerial effectiveness. The selection between the function of expense method and the nature of expense method shapes the financial statements' analytical value, transparency, and comparability.

IFRS allows both classifications but emphasizes consistency and relevance.

IFRS (IAS 1) offers entities the flexibility to classify expenses according to function or nature, allowing them to reflect the most relevant and faithfully representative information for users of the financial statements. This decision is not simply a matter of format preference but should be rooted in the company’s operating environment, internal reporting, and the needs of primary users.

By nature: Expenses are aggregated according to their intrinsic type, with no allocation to functional categories. Each line item shows a specific expense type—such as raw materials, depreciation, or employee benefits—allowing direct tracing from general ledger accounts to the income statement. This method enhances transparency regarding cost composition, making it easier to spot changes in the business’s cost structure or vulnerability to external factors (such as labor cost inflation or energy price shocks).
By function: Expenses are grouped and allocated to the functional areas they support, such as cost of sales, administrative expenses, distribution costs, or research and development. This method facilitates a direct link between the statement of profit or loss and the company’s operational structure, allowing users to assess how resources are consumed to generate revenue and to calculate key metrics such as gross profit and operating profit. Allocation requires managerial judgment and robust internal controls, as overheads and indirect costs must be assigned across multiple functions.

IAS 1 requires:

A consistent application of the chosen method from period to period, ensuring trends and comparisons remain meaningful.
Explicit disclosure and explanation if the method changes, including restated comparatives and rationale for why the new method provides more relevant or reliable information.
Additional breakdowns in the notes (when function is chosen) to ensure users can understand the cost structure even when expenses are aggregated by function.

Example (by nature)	Example (by function)
Raw materials consumed	Cost of goods sold
Employee benefit expense	Selling and marketing expenses
Depreciation and amortization	General and administrative
Utilities and office supplies	Research and development

In practice, large industrial or manufacturing entities often favor the function of expense approach for external reporting, as it aligns closely with management reporting and performance evaluation. In contrast, smaller, service-oriented, or nonprofit entities may lean toward the nature of expense method, prioritizing transparency and simplicity.

US GAAP generally uses functional classification with limited flexibility.

US GAAP and the SEC establish more prescriptive requirements for expense classification, particularly for public companies. The multi-step income statement—which separates operating revenues and expenses from non-operating activities—is the dominant format. Expenses are categorized primarily by function, and presenting by nature on the face of the income statement is not permitted for SEC registrants.

Functional categories required or expected under US GAAP and SEC rules:

Cost of goods sold (COGS): Direct and indirect manufacturing costs tied to goods sold.
Selling expenses: Advertising, sales staff compensation, shipping, and delivery.
General and administrative: Executive salaries, office expenses, legal and IT costs, utilities, rent, insurance.
Research and development: Product design, engineering staff, laboratory costs, patent-related fees.
Other operating expenses: May include restructuring charges, asset write-downs, or impairment losses.

The single-step format (all revenues and gains grouped together, all expenses and losses grouped separately) is permitted, but is rare among large US public companies due to the lack of analytical subtotals.

Note disclosures under US GAAP may present additional detail, such as the nature of significant expense items or a reconciliation to internal management reporting, but there is no requirement to break out expenses by nature on the face of the income statement.

Regulation S-X (SEC): Specifies minimum presentation lines and order for income statements of public registrants, further cementing the dominance of the function-based approach. Variations are only permitted with SEC pre-approval.

This functional emphasis supports comparability across firms, industries, and reporting periods, facilitating ratio analysis and investor benchmarking but often limits the transparency into underlying cost drivers.

The nature of expense method emphasizes transparency and direct attribution.

When using the nature of expense method, companies report expenses based strictly on their inherent type, with no attempt to allocate indirect costs to operational functions. This approach maximizes visibility of core cost drivers, simplifies reconciliation to underlying accounting records, and is particularly beneficial for entities with straightforward or service-centric business models.

Typical line items under the nature of expense method:

Employee benefit expenses: Wages, salaries, bonuses, social security contributions.
Raw material and consumables used: Direct materials, components, and supplies consumed in operations.
Depreciation and amortization: Charges for the systematic allocation of tangible and intangible asset costs.
Repairs and maintenance: Routine maintenance costs for fixed assets.
Utilities and energy costs: Electricity, fuel, water, and other consumables.
Professional services: Outsourced IT, legal, or consulting expenses.

Advantages:

Simplicity: Eliminates the need for sometimes subjective cost allocations.
Transparency: Offers investors and analysts immediate insight into trends, risks, and cost control effectiveness (e.g., tracking wage inflation or raw material price volatility).
Suitability: Well-aligned for service entities, startups, nonprofits, and any company where functional allocation does not add decision-useful information.

Drawbacks:

Less suited for manufacturing or multi-segment businesses where function-based performance metrics (e.g., gross margin, contribution margin) are essential.
May obscure links between cost and operational performance, making it harder to compare with industry peers who use functional classification.

Companies applying the nature method should ensure consistency over time and robust disclosures to explain major cost drivers and any unusual fluctuations.

The function of expense method supports gross profit and segment analysis.

The function of expense method aggregates costs based on the operational activity they support—production, selling, administration, or research—allowing for sophisticated analysis of profitability, efficiency, and cost management. This classification is fundamental for stakeholders evaluating operational leverage, gross and operating margins, and the allocation of resources to value-generating activities.

Example multi-step income statement using the function method:

Line item	Amount ($)
Revenue	1,200,000
Cost of goods sold	(600,000)
Gross profit	600,000
Selling and marketing expenses	(120,000)
General and administrative expenses	(180,000)
Research and development expenses	(90,000)
Operating income	210,000

Analytical benefits:

Gross profit calculation: Cost of goods sold is isolated, enabling clear measurement of production efficiency and direct margin on sales.
Operating margin analysis: Grouping selling, general and administrative, and R&D expenses highlights cost structure and managerial control.
Segment disclosures: Facilitates alignment with internal management reporting and external segment disclosures under IFRS 8 or ASC 280.

Challenges:

Subjectivity: Allocating shared or indirect costs (e.g., IT, HR, rent) to multiple functions can require complex, judgment-based methods.
Comparability risk: Differing allocation policies between companies can hinder cross-company comparisons or lead to inconsistent trends over time.

The function method is widely used by large manufacturers, retailers, and conglomerates, where alignment with operational structure is critical for performance evaluation and strategic planning.

IFRS requires nature-based disclosure even when function-based presentation is used.

IAS 1 specifically requires entities using the function of expense method to provide a supplementary breakdown by nature in the notes to the financial statements. This dual disclosure ensures that users are not deprived of transparency into underlying cost drivers.

Key disclosures include:

Depreciation and amortization expense: Total amount recognized during the period.
Employee benefits expense: Aggregate personnel costs.
Raw materials and consumables used: Total direct and indirect material costs.
Other significant cost categories: Utilities, outsourcing, professional services, etc.

Benefits of supplementary disclosure:

Transparency: Enables analysts to track major trends, such as rising labor or energy costs, even when expenses are grouped functionally.
Comparability: Bridges the gap between companies using different primary presentation methods.
Analytical flexibility: Allows both high-level performance benchmarking and detailed cost structure analysis.

Failure to provide these disclosures can impair the usefulness of the statements and may result in regulatory or audit findings.

Changing classification method requires justification and restatement under IFRS.

A change in expense classification method under IFRS is treated as a significant change in presentation. It can only be made if the new method provides information that is more reliable and relevant to users. Companies must provide a robust explanation for the change, restate prior period figures for comparability (unless impracticable), and detail the impact in the notes.

Process:

Management decision: Justify the new classification as more reflective of business model or user needs.
Restatement: Adjust prior period comparatives to reflect the new method, ensuring trend analysis remains valid.
Disclosure: Clearly explain the nature of the change, the rationale, and the quantitative impact on each affected line item.

Example scenario:

A diversified conglomerate undergoes strategic realignment, leading to a shift from function to nature classification. Management must articulate why the change increases transparency and provide a full comparative reconciliation.

Auditors and regulators will scrutinize such changes to ensure compliance and to prevent manipulation of reported results.

Choosing between the methods affects KPIs, comparability, and audit risk.

The decision between classifying expenses by function or by nature has far-reaching effects beyond financial statement aesthetics. It shapes:

Key Performance Indicators (KPIs): Gross and operating margin analysis is directly supported by functional classification. Nature classification, while more transparent, limits certain margin analyses and trend detection.
Comparability: Standardized function-based reporting enables peer comparison and sector benchmarking, especially for investors and analysts.
Audit and control risk: Allocating indirect costs between functions introduces estimation and allocation risk, requiring robust internal controls and documentation. By nature, reporting is less subjective and reduces audit complexity.
User understanding: Functional classification may mask cost drivers but improves operational performance focus. Nature classification offers immediate insight into expense trends and vulnerabilities.

Criterion	By function	By nature
Operational clarity	High—direct link to segments/functions	Lower—shows cost composition
Ease of audit	More complex—requires allocations	Simpler—direct attribution
Performance metrics	Enables margin and efficiency analysis	Limits margin calculations
Transparency	Can obscure drivers if allocation opaque	High—clear expense drivers
Industry comparability	High in sectors using functional reporting	Lower, unless all peers use nature method
IFRS disclosure	Requires nature breakdown in notes	Fully meets requirement
US GAAP disclosure	Function-based required, notes by nature optional	Function not permitted on face, notes only
Restatement requirement	Yes, with justification	Yes, with justification

A company’s choice should reflect its operational realities, the informational needs of users, and compliance with the applicable standard. Regular review of classification policy is warranted as businesses evolve, but changes must be justified, disclosed, and implemented with full transparency.

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