Depreciation, in the accounting sense, is the bookkeeping process of lowering the value of something that your organization owns over time. It is generally applied to physical or tangible objects that an organization uses long-term.
Disclaimer: What is a blog post about a legal or financial topic without a disclaimer? This is not legal advice. You should not be getting your legal advice from a blog post. The purpose of this post is to give you things to think about before taking action. Speak to an accountant and/or a lawyer about specifics. This article will discuss depreciation specifically in the context of tax-exempt, non-profit organizations. United States tax law has provisions for individual musicians to depreciate their personal instruments but that is beyond the scope of this article. Additionally, for organizations, this article does not constitute accounting advice from the author. Obtain the advice of a CPA for guidance in implementing these ideas at your organization.
Explaining the Concept
It’s helpful to illustrate this concept by thinking of the opposite situation: physical or tangible objects that an organization uses just once, and quickly. Some very common examples include consumable office supplies such as pens and paper clips, disposable cups and napkins at your lobby concessions stations, and branded stationary on which you write donor thank-you notes. You buy these things for single usage and they are “used up” in a matter of months if not less.
Long-term usable objects, what the accounting industry calls “Fixed Assets,” include major office equipment such as computers. Specific to arts organizations, fixes assets include instruments owned by the organization itself such as pianos, stage equipment such as acoustic shells and platform risers, and recording equipment. Your organization expends the full cost of these items at one particular point in time, but uses them for multiple years. In the case of the piano, for example, it could be over ten years.
The idea behind depreciation is to spread the cost of the pianos, computers, and other items across multiple years. These are generally expensive items, with a purchase price in the thousands of dollars. Even though you purchased that piano in 2018, you are still making use of it for performances that generate ticket revenue in 2023. Depreciation allows you to put a portion of the cost of the piano in the same year as it is used for those performances to earn that revenue. This balances your revenues and expenses to reflect the a clearer “cost” of your programs.
To do this, we say that we “capitalize” rather than “expense” the purchase of the piano, computer, or other item. The minimum purchase price to qualify an item for this process is called the “capitalization threshold.” Instead of entering the invoice from the vendor to your “Office Equipment” account on your Statement of Activities (also called the Profit & Loss, or Income Statement), you enter that invoice to the “Fixed Assets” account on your Statement of Financial Position (also called the Balance Sheet) as of the date of purchase.
Separately, divide the purchase price by the number of years in the item’s “useful life.” This, too, is an accounting term that doesn’t necessarily correspond to the precise timeframe the object will be in use. Even two identical laptops purchased on the same day may be used for different lengths of time before they are replaced based on the usage patterns of the employees assigned them. It’s a best practice to have an organizational standard for the “useful” life of computers, stage equipment, pianos, percussion instruments, and other categories, and there are a number of resources (including some from the IRS) that provide industry standards/guidelines. Your auditor can assist with this as well.
Once you’ve completed those calculations, use the result (purchase price divided by useful life in years) and create a journal entry in your books to debit the “Office Equipment” account (to assign a portion of the price of the computer to the current accounting period) and credit the “Fixed Assets” account (to reduce the value of that computer that your organization owns – assets being the accounting term for everything your organization owns). Perform these journal entries at least yearly, but for larger organizations that prepare more frequent detailed financial reports, doing so quarterly can be worthwhile.