If you have any involvement in your nonprofit organization’s financial reporting, you’ve probably seen a line item called “depreciation.” You might know that depreciation is a yearly income tax deduction that is listed as an expenditure on an income statement; however, do you truly understand depreciation and how depreciation can affect your organization’s financial statements?
What is depreciation?
The purpose of depreciation is to enable a business or organization to reduce the value of an asset over a period of time, eventually recording the full cost of the initial purchase. In order to depreciate an asset, you must be the owner of that asset (it cannot be leased) and it must have a useful life of more than one year. Assets that are frequently depreciated include buildings, computers, equipment, machinery, and office furniture. You cannot depreciate land (since it does not get “used up”) or inventory (since it is intended to be resold).
At Altruic Advisors, we use the straight-line accounting method to compute depreciation, both for financial statements and for the Form 990. The straight-line method spreads the initial cost of the asset evenly over its useful life.
For example, here is how we would calculate straight-line depreciation for a fixed asset:
Depreciation = ([Initial Cost of the asset] – [Residual Value]) / [Useful Life]
Residual Value: Expected resale value of an asset at the end of its useful life
Useful Life: Time period (years or months) that the asset is anticipated to be used
How does depreciation affect net income?
Depreciation expenses directly impact net income. Recording a high-dollar fixed asset purchase (like a brand-new computer) all at once could negatively affect your bottom line; however, when you depreciate an asset you can spread the cost out as a long-term expense over a number of years. But remember, depreciation expenses do not affect your cash flow since depreciation is a non-cash expense. You still have incurred a high-dollar purchase - and that will definitely affect the cash in your bank account!
The next time your nonprofit is looking to purchase new office furniture, a new computer, or an expensive piece of equipment, don’t forget to give your accountant a call. It’s important to keep your accountant informed about the purchase of new assets so they can be properly documented and depreciated, and your net income will never be more affected than it has to be.