Depreciation is seldom given the respect it deserves. For many who are first encountering the term, it is a mysterious financial concept best considered only by CPAs. At Nonprofits Assistance Fund, we hold depreciation among our favorite tools for building reserves and planning for the future stability of an organization.
To understand depreciation, we need to first understand a basic accounting practice. When a nonprofit buys a piece of furniture or a computer or a building, these items have lasting value and usefulness. Instead of immediately recording the entire purchase price as an expense on the financial statements, the item is booked as an asset. An asset is a resource that is available for use now and into the future. These sorts of purchases are often more specifically called fixed assets.
The nature of most fixed assets is that their value will diminish over time. The new conference table begins to get scuffs and dings. After a few years, the computer, once state of the art, seems painfully slow when loaded with the most recent software. The roof of the showcase building moved into ten years ago is beginning to show signs of wear.
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In order to account for the declining value of fixed assets, we use an accounting entry called depreciation expense. For each year of the useful life of a fixed asset, we book a share of the original value of the purchase as depreciation expense. A simple way to determine the amount is called the straight-line method. We take the original purchase price and divide it by the number of years the item is likely to be useful. There are some standard timelines that are commonly used. Computers are often depreciated over three years. Office furniture is often depreciated over seven years. For example, if we paid $700 for a conference table and depreciated it over seven years, each year we would book $100 as depreciation expense. The unusual feature of this transaction is that the cash was actually spent on the item when we purchased it. Depreciation is simply accounting for the decline in its value over time—no cash is going out the door at the time we record depreciation expense.
The great benefit of tracking and booking depreciation is that over time it can build our organization’s financial reserves. With a proper allocation system in place, depreciation expense will be shared appropriately among each department or cost center in your organization. In turn, the funders of each program will pay for their fair share of the depreciation expense. This is reasonable to ask of our donors because we are using the fixed assets to do the important program work they fund.
The reserves we grow in this way become part of the foundation for our future financial health. Funding depreciation is a fantastic method of adding to the strength of our balance sheet. As we accumulate reserves, we become more able to adapt to volatility in our funding sources, to endure unexpected expenses, and, ultimately, to respond to emerging mission opportunities we could not anticipate when we created our budget. If you are not already doing so, add depreciation expense to your current budgeting practices and boost your organization’s financial health. We hope you, too, will soon come to see depreciation as one of your favorite tools for building a healthier nonprofit.