Sometimes depreciation works against a nonprofit organization, usually because one of the basic theories does not apply. A good example is a youth after-school music education program that needs to purchase musical instruments. These instruments are basic to the organization’s main activity (teaching youth about music) and are actually the perfect opportunity for a new fundraising campaign. (Your donation of $100 is 1/12th the cost of a new flute for Audrey!)
Questions to ponder
Is it in the best interests of the organization to fully cover the cost of its depreciation expense every year in order to show an operating profit? What if the annual depreciation expense for musical instruments is so large, the organization must give up two part-time teaching positions in order to show a small profit? Or instead does the board and management decide to “under-fund” depreciation expense in order to add back the teaching positions, and accept an annual loss in their budget?
What can this organization do with an outsized depreciation expense each year? Depreciation rules were created with for-profits in mind. Since there are no exceptions for nonprofits, it is best to address this issue with financial planning and updated financial report layouts. To start, the organization can move their annual depreciation expense out of the “Operating” area to the bottom half of the P&L statement under “Other Financial Activity”. They can also separate the depreciation total into “Musical Instruments” and “Admin/Other” to further clarify.
This way, depreciation is pulled out of the mix when calculating the Operating net results (profit or loss) each year. The bottom line results (grand total) for the year is still the same, but the organization is able to show a profit in ongoing operations when depreciation expense is removed. It is a reasonable request to have your audited financials adjusted in this fashion. If your auditor refuses, then ask them to break depreciation expense out into its own section on their reports, away from all the other operating expenses. This makes it easy to quickly show donors the reason for an operating loss that year.
In your internal financial reports, you should move depreciation expense out of Operating to the Other Financial Activity section. This gives clarity for important management decisions about fundraising needs and whether the current business model is able to support ongoing operations activity or not.