What is depreciation? Why does it exist? Was it created just to torment you, forcing you to show a loss for the year when you actually had a surplus in real life?
A lot of misunderstanding, fear and loathing exists around depreciation, yet it is possible to become friends. It helps to first understand the concepts behind it and what it is trying to accomplish. Then you can utilize it in your financial planning. Think of depreciation expense as a “reminder system”.
Why is this expense spread out over several years?
When you spread the expense of a large purchase over several years, you turn it into an asset. An asset is a long-lived item which is used by your organization over multiple years. This differs from office supplies or monthly rent payments, which are used up in a short period of time. Each year you are using a percent of the asset’s useful life span. This creates an expense for each fiscal year until the original cost is used up.
What happens when the depreciation period ends and I am still using the same asset?
It very common to use assets past their depreciation life for a year or two. When you do, your annual profit is slightly inflated because you are using old assets to perform your work. There is no depreciation expense to offset your revenue. As long as you keep showing a profit at the end of each fiscal year, your depreciation savings are safe in the bank to buy a new asset when you finally need it.
However, nonprofits often fall into a vicious cycle of using assets long past their useful life. Cathy Jacobowitz calls nonprofit organizations “the land of broken chairs” for their reluctance to replace the most basic of assets. Reasons include the lack of a cash cushion to spend the funds, or even fear that the “new” annual depreciation expense will push the P&L into a loss for the year. Once a tight annual budget has thrown off the depreciation expense line item, it is hard to add it back.
For this reason, it is better to slowly replace assets in a continual cycle rather than buying things in large batches and using them into the ground. For example, an organization with 10 staffers should buy two new computers annually. Each computer is replaced every five years and the annual technology expense is consistent over the years. This type of asset planning also makes for good financial planning. There is no large variation from year to year on the balance sheet or the P&L for these line items, and all your workers have functioning computers to do their jobs.
How do I show depreciation with accounting?
It’s easier to explain by showing an example:
This year you paid $2,100 for a souped-up graphics-design computer system. Technology has a standard three-year depreciation rate. (Depreciation rate means “How many years does it last?”) To compute your new computer’s annual depreciation amount, divide $2,100 by 3 years = $700 annual. So over three years, you will expense $700 annually for your new computer. The balance of the not-yet-expensed cost lives on your balance sheet as an asset (something you own).
In year 4, the graphic-design computer is “free of charge” – no related expense. The nonprofit has already saved $2,100 in the bank to buy a new one. At this point, a prudent management buys a new graphics-design computer and uses the original computer to replace the wretched intern’s ancient one.