For board members who do not have a background in finance and accounting, the concept of depreciation can be somewhat of a mystery. What is it really? And if no one is showing up on our organization’s doorstep with a bill for depreciation, do we really need to “fund” that expense line?
As the conversation below illustrates, the reality is that funding depreciation can be a critical piece of an organization’s financial management strategy, especially if your organization owns a building.
Imagine you are a new board member for Community Theater Productions, a local theater company that has been providing quality productions and educational programming in your local community for nearly 50 years. It is your first board meeting and one of the board’s tasks for the meeting is to approve the budget for the coming season.
You’ve read it over and, in general, the budget makes perfect sense. While there isn’t much of a surplus, the organization isn’t planning on running a deficit, which seems positive. There are lines for staff salaries, actors, costumes, fundraising, marketing, and many other expenses that seem essential to running the theater. But one line stands out: depreciation, a single line item, makes up almost 5 percent of the total budget.
Where in the world is all that money going, and couldn’t it be put to better use in an organization that is barely breaking even? You decide to schedule a call with the Board Treasurer, Cathy, before the meeting to better understand the need for depreciation in the budget.
You: Cathy, thanks for chatting with me. First of all, what exactly is depreciation?
Cathy: Depreciation is the way we account for the wear and tear of our fixed assets, like our building or large equipment. Instead of accounting for the full value of a large asset in the year we buy it, which would show up as a huge expense and would require a significant amount of funds all at once, we figure out the useful life of our assets and divide out the expense over how long we think we’ll use it. Essentially, each year we want to account for how much of the asset we are using that year. In our case, because we own the building our theater is in, fixed assets are a huge portion of our resources to operate and therefore depreciation makes up a large part of our budget.
You: Okay, but where is the money actually going? Is this like a mortgage payment?
Cathy: No, we are lucky that we own our building outright and don’t owe a mortgage. But even if we did, depreciation is different. It’s not cash going to pay for the building, because we already paid for the building when we bought it. Technically, depreciation is a non-cash expense, so the cash doesn’t have to go anywhere. In our case though, we actually take that depreciation amount and we transfer it into a capital fund each year, where we can hold that money for any replacements or or any new large asset purchases we need to make. That is what we refer to as our capital budget.
You: Got it, that makes sense. It’s like we’re saving for future purchases.
Cathy: Exactly. Capital investments are a huge expenditure when they come up, and there can be a lot of risk associated with them. What if we needed to buy a whole new lighting system for the theater suddenly? That actually happened a few years ago. We could have undertaken a capital campaign to raise money, but that would have taken months, and in the meantime, we wouldn’t have been able to produce any shows. Funding depreciation every year allowed us to fix the problem immediately and go on with our season. I’ll be honest, we haven’t always been able to fully fund our depreciation amount in some of our leaner years, but we always put as much as we can into the budget, and into the capital fund each year.
You: Thanks Cathy, this was really helpful. In fact, I’m also on the board of the Community Music School and I’m not sure we’re properly accounting for the depreciation of our building. I’ve seen it on the audited financial statements, but not in the budget. I’m going to bring it up at our next meeting.
Hilda Polanco is the Founder and CEO of Fiscal Management Associates, the go-to advisor foundation and nonprofit leaders seek when addressing nonprofit financial management capacity. Hilda provides capacity building, training and coaching services to foundations and nonprofits throughout the country.