Funding Depreciation

Should facility managers fund depreciation?  I want to cover the concept of funding depreciation because it is something that I wrestle with still to this day.  This is one of the more overlooked concepts that I consider important to the future financial health of the organization.  If you haven’t already wondered what happens when an asset reaches the end of its useful life, you were bound to.  In many cases the organization really has no plan how to deal with these assets and instead limps along with a repair budget, only replacing them out of the capital budget when they just can’t be fixed any more.  This is not the best way to plan asset replacements.

What is Depreciation?

Depreciation is a non-cash deduction (expense) used by accountants to spread the cost of a physical asset over its useful life.  You will most commonly see it and hear about it when referred to property, plant, and equipment.  For most PP&E, the value of the asset goes down over time as it ages and is used.  Depreciation is a way to show reduced value of the asset year after year.

So why do accountants depreciate assets?   There are two reasons: accounting and taxes.

  • Accounting – to put it simply, accounting principles require organizations to recognize (or record) revenues and expenses when they occur. This is known as the realization principle (or recognition principle).  For instance, when you sell a product you would record the sale when it happens, not when the customer actually pays the invoice a month later.  If we apply this to capital assets, however, the process can get a little confusing.  Consider a huge construction project that spans multiple years.  If the end result is a single building, how do you record that revenue when it accrues?  You can’t wait until the end of the third year to record the entire sale. An extension of the realization principle is the matching principle.  This principle states that you record expenses incurred in producing a product at the same time you record the sale of the product.  For instance, if you produce a machine and sell it on credit, you record the revenue the day the sale is made (not when the cash exchanges hands) along with all costs associated with the sale of the product.  This is why we depreciate assets.  We want to recognize the portion of the asset’s value that contributed to the company’s operation during the same period of operation.  An example is if you have a machine that is expected to last five years, you might depreciate 20% of its value every year for the next five years until it’s residual value is zero.
  • Taxes – the second reason to depreciate assets is to gain a tax advantage. Because the depreciation expense has consequences on cash flow, it will influence the tax bill.  The organization might be able to take advantage of tax laws and be better positioned financially utilizing depreciation.

What is Funding Depreciation?

Funding depreciation means the organization invests an amount of money every year into a depreciation account equal to the amount of the depreciation expense that year.  So if Company A wrote off the $5,000 machine at $1,000 per year over five years, they would then turn around and invest $1,000 per year over five years into an account (or certificate of deposit, money market account, etc.).  The result is that Company A would have $5,000 available to buy a replacement machine at the end of its useful life.  Company A could then decide when to replace the machine or could automatically replace it as part of a life-cycle replacement program (replacing the asset at the end of its useful life).

The problem, however, is that many organizations need the cash they would use to fund depreciation for other operating expenses and it never ends up happening.  Another issue is that only funding depreciable assets won’t be enough to maintain operations.  Consider a building that requires repainting.  Paint is not depreciable, but you will most assuredly need to repaint prior to the end of the building’s useful life.  Finally, if companies use debt to purchase the asset, there ends up being monthly two cash outlays during its useful life: the debt-service payment and the funding of depreciation.  That can make it very hard on the company’s bottom line.

Should Facility Managers Fund Depreciation?

So in a perfect world, I would argue that yes, FMs should absolutely fund depreciation.  However, for the reasons listed above, funding depreciation becomes very difficult.  It is hard to walk into a board room and convince key decision makers why they need to stick cash that they have currently into an interest bearing account so that they can replace something they already own at some point in the future.  This is especially true when the counter-argument is to invest in the growth of the company by using the cash elsewhere.

That said, replacing assets at the end of their life-cycle is also extremely important to the ongoing operations of the organization you work for.  It is an equally hard proposition to walk into the same board room and convince the key decision makers why they need to come up with money they don’t have to replace something that was working just fine yesterday.

In Summary

The best I can come up with is that it is a balance.  It is a give-and-take with your capital budgeting cycle and implementing a good twenty-year capital plan that lists out exactly when all assets will need to be replaced and an estimate on how much it will take to do that.

How many of you have organizations that fund depreciation?  I would really love to know how that’s working for you and how you convinced them to do it.  Please feel free to leave comments below.  As always, you can also reach me at dan@learningfm.com.  Thanks for reading!

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