Five Minutes for Finance - Depreciation
Depreciation for Nonprofit Organizations
One of the most confusing topics for non-accountants is depreciation.
Depreciation is a key accounting concept that applies to nonprofit organizations just as it does to for-profit businesses. It refers to the process of allocating the cost of a tangible fixed asset over its useful life. This helps nonprofits spread out the expense of an asset, such as buildings, equipment, or vehicles, rather than recognizing the full cost in the year of purchase.
Definitions
Fixed Asset: A fixed asset is any item that an organization purchases that has a useful life of more than one year. Examples of fixed assets include furniture, buildings, computer equipment, software, and tenant improvements made to leased facilities.
Useful Life: The useful life of an asset is the length of time that the asset provides value before it is fully depleted or becomes obsolete. Each organization determines the useful life of an asset based on its planned use and industry standards. Common useful life benchmarks are:
Computers and related equipment: 3 years
Vehicles: 5 years
Office furniture and fixtures: 7 years
Buildings: 20 years
Land or business property improvements: the lesser of 15 years or the remaining life of the lease
Capitalization: This refers to the accounting concept of recording the acquisition of a fixed asset such that it reflects the exchange of one asset (cash) and/or liability (debt) for another asset (fixed asset). The cost of the fixed asset is not recorded as an expense in the period in which it was acquired. Rather, the cost is recognized incrementally as depreciation expense each year of its useful life.
Capitalization Threshold: In order to simplify and streamline the accounting process, organizations typically establish a capitalization threshold, under which asset acquisitions are treated as regular expenses in the period rather than as fixed assets. These thresholds typically range from $500 to $5,000, depending on the size of the organization.
Matching Principle: This principle requires organizations to recognize expenses in the same accounting period in which they generate related revenues. In the case of depreciation, the monthly or annual depreciation expense, which represents the monthly or annual portion of the fixed asset’s cost basis, is recorded in the same period in which the related revenues are recognized. For example, the depreciation expense of a vehicle is recorded in the same accounting period as the revenue generated when that vehicle is used to deliver meals to the community (thus generating revenue).
Salvage Value: In some cases, a fixed asset may still retain some value at the end of its useful life. This remainder is called the salvage value. If the asset is sold or disposed of, the salvage value is included in the calculation of net gain or loss on the sale/disposal of the asset.
Cost Basis: The full cost of purchase, delivery, customization, and installation are all included in determining the cost basis of the asset.
Depreciation Expense: The depreciation expense is the monthly or annual amount recorded as an expense. The sum total of depreciation expense over the useful life of a fixed asset equals the cost basis (less any salvage value).
Accumulated depreciation: This balance sheet account is a contra-asset that captures the total of depreciation expense recorded since acquisition.
Net Book Value: The net book value (NBV) of a fixed asset is the cost basis less any accumulated depreciation.
Why Depreciation Matters for Nonprofits
Accurate Financial Reporting: Nonprofits are required to maintain accurate financial records to ensure transparency and accountability to donors, grantors, and regulatory bodies. Depreciation allows nonprofits to reflect the gradual wear and tear of assets in their financial statements. By doing so, they can more accurately report their true financial position.
Budgeting and Financial Planning: Depreciation affects a nonprofit’s net income, which is crucial for budgeting and long-term financial planning. Nonprofits need to account for the gradual decrease in the value of their assets so that they can allocate funds for future replacements or repairs. This ensures that the organization doesn’t experience unexpected costs when assets need to be replaced or upgraded.
Tax Considerations: Although nonprofits are generally exempt from paying taxes, they may still benefit from tax incentives. Depreciation can impact certain tax filings, particularly for nonprofits that generate unrelated business income (UBI). By depreciating assets, nonprofits can lower their UBI, potentially reducing the amount of tax they owe. Depreciation is also helpful when reporting on grants or other income where specific requirements for asset value may exist.
Donor Transparency: Nonprofits often receive donations of fixed assets such as property or equipment. Depreciation is crucial to reflecting the true value of these donated items over time. Proper depreciation practices help maintain credibility with donors by showing how donated assets are being utilized and maintained.
Planning: As fixed assets are used and depreciated, the net book value of the asset will decrease over time. Organizations should monitor the net book value of their fixed assets to anticipate the need to replace these assets as they approach the end of their useful lives.
Depreciation Methods for Nonprofits
Nonprofits can choose from several methods to calculate depreciation, with the most common being:
Straight-Line Depreciation: This is the simplest and most widely used method. It spreads the cost of the asset evenly over its useful life. For example, if a nonprofit purchases a $10,000 asset with a 10-year useful life, it would depreciate $1,000 each year.
Accelerated Depreciation: Some nonprofits may choose accelerated methods, like the Double Declining Balance method, to depreciate an asset more quickly in its earlier years. This is typically used when assets lose their value faster upfront.
Units of Production: This method is based on the actual usage of the asset. For example, a nonprofit that owns a printing press might depreciate it based on the number of hours the press is in operation.
Depreciation Tools and Process
Schedule of Fixed Assets/Depreciation Schedule: This schedule lists all of the organization’s fixed assets with the following information:
Name of asset
Location of asset (optional)
Serial number of asset (optional)
Cost basis
Acquisition date
Useful life
Salvage value (if any)
Depreciation method
Periodic depreciation expense (monthly or annual)
Accumulated depreciation
Current Net Book Value
Depreciation Expense and Accumulated Depreciation: Each month or year, the organization records the depreciation expense in the general ledger. The general ledger entry will record the depreciation expense and add it to the accumulated depreciation account.
NOTE: Because depreciation is a non-cash expense, care should be taken when forecasting cash flows. If cash flow forecasting is based on accrual-based budgets or financial statements, depreciation should be excluded from the forecasted cash outflows.
Conclusion
Depreciation is an essential aspect of nonprofit accounting, ensuring that an organization’s financial statements accurately reflect the wear and tear on its assets over time. By using depreciation, nonprofits can improve financial transparency, plan for future capital needs, and meet tax or reporting requirements. Proper depreciation practices not only help maintain fiscal responsibility but also contribute to the long-term sustainability of the organization.
About this Series
Subsequent articles in this series will cover other topics related to nonprofit financial management. Here is a list of, with links to, previous articles:
About the Author
For over 30 years, Robert Pascual has been a leader in nonprofit financial management as a CFO, consultant, conference speaker and educator. He holds an MBA from the Haas School of Business at the University of California and is the founder and principal of Robert Pascual, MBA LLC. He has worked with small, mid-size, and large nonprofit organizations spanning the fields of education, workforce development, housing, health, philanthropy, social services, media, fiscal sponsorship, nature, and the environment. Each of these organizations has faced both unique and common challenges, some of which are probably similar to ones that you wrestle with.