Depreciation is an accounting estimate of the general wear and tear on your organization’s fixed assets. It reflects the fact that physical assets like buildings or equipment lose value over time and eventually need to be replaced.
Depreciation is a way of spreading out the cost of fixed assets over their useful life. Each year, the Statement of Activities shows a depreciation expense, representing the estimated annual decline in value of all fixed assets, based on their cost of acquisition and useful life. The Balance Sheet then reflects the cumulative amount of depreciation at any point in time.
Ignoring depreciation is a risky strategy. Just because no one sends your organization a bill for depreciation doesn’t mean it doesn’t matter. If your organization has no cash-on-hand when the roof begins to leak, the HVAC breaks down, or production equipment becomes obsolete, you put your programs and organization at risk.
A smarter strategy is to set aside savings each year into a reserve dedicated to the future care of fixed assets. Ideally, the value of this reserve will approximate the amount of accumulated depreciation on the balance sheet. Some organizations use the depreciation expense from their Statement of Activities as a proxy for the amount they should save each year. An even better method for estimating savings needs is an engineer's assessment of the size and timing of future repairs and replacements.
Many organizations find it difficult to cover annual depreciation expense with operating revenue alone. They may periodically need to raise additional capital through special fundraising efforts, or a campaign. However, it’s risky to delay fundraising for depreciation until a specific need arises. Organizations should always have some savings on hand for the unexpected emergency.
Management Tip: Consider hiring a qualified engineer who can provide an estimate of your organization’s future fixed asset needs. Then, align your savings goals to these needs, and budget to meet them. If you can’t afford an engineer’s assessment, use depreciation expense as your savings guide. Savings for future fixed asset replacements should be set aside in a dedicated cash reserve.