February 2013, Vol. 25, No.2

Extra

Decoding depreciation

Plan now for repairs and replacements tomorrow

Karl Birky and Erik Grimstad

Managers and employees of water resource recovery facilities (WRRFs) should beware of anyone who says, “Depreciation is not a real expense.” When these words are heard from a manager, executive, city council member, or board member: Run. Do not stop! Shout, “No, it’s not true!” Keep running!

Depreciation is a real expense, and if it is not funded, it will get the organization in trouble — serious trouble. Buildings, furniture, and equipment don’t last forever. After a period of use, they will either need major repairs or replacement. Funding depreciation means putting money in the bank as things wear out, beginning the day they are put in service. Done correctly, funding depreciation will provide enough money for replacement without tying up too much extra cash.

Although depreciation is not an expense that requires a monthly check, it is an expense — an estimate of the wear and tear on depreciable assets. It is important to study the mechanics of calculating and tracking depreciation for financial reporting purposes. And it is even more important to establish a strategy to fund depreciation so that major repairs and replacement can be accomplished as needed.

 

Ignorance is not bliss 

Often, an organization with a negative net income (losing money) can report a balanced budget if it doesn’t fund depreciation. When anyone raises concerns over the financial health of the organization due to lack of funding for depreciation, the chief financial officer (CFO) may explain, “Well, if we leave out the depreciation expenses — after all, it’s not a cash expense — from the loss side, we show net income.” The CFO and the CEO (in this case) believe depreciation really isn’t a cost, since no cash is spent. No cash is used, so the organization doesn’t need to worry about it.

Here’s the truth: Everybody needs to worry about it. WRRFs get old and wear out. Equipment must be replaced. If depreciation is funded, the money is set aside for this. As an added benefit, funds set aside for this purpose can accrue interest.

If WRRF managers have not set aside money to fund depreciation, then not enough cash exists on hand to pay for the replacement. In that case, instead of paying for the replacement or repair from an account that has been earning the organization money, a loan must be obtained. The amount that must be paid back to the bank is more than the organization needed to tuck away to fund the depreciation of the asset.

This is the true benefit of funding depreciation — there is no lapse in service to the community while a loan deal is figured out (assuming the organization has enough credit to warrant a loan), and it costs the ratepayers less overall, compared to paying back a loan with interest. Many organizations have learned this lesson the hard way in the recent economic downturn.

 

Learning from the private sector 

Depreciation often is easier to explain than it is to fund. Funding depreciation can be painful. With so many demands on resources, it seems wasteful to have money sitting in an account instead of going toward the many worthwhile projects that could use it. But greater is the pain of worn-out pumps and trucks that can’t be replaced for lack of cash.

Depreciation is one of those life truths: “You can pay me now, you can pay me later, or you can close up shop and go home.” When considering funding depreciation for most organizations, including WRRFs, the third option is nearly nonexistent. A fourth option city council and board members will consider when equipment has to be replaced and the funds are not available is to replace the WRRF manager and CFO who told them that “depreciation is not a real expense.”

City councils can sell or lease a facility to an investor who will make three changes immediately:

  1. Ensure that a profit is made by cutting expenses.
  2. Ensure that depreciation is funded so the WRRF, the toll road, or whatever service is at hand is viable in the long term.
  3. Arrange things so it is difficult for the city council or board of directors to wrest back control of the facility.

Some cities with poorly managed WRRFs have benefited from contracting management to a for-profit corporation or leasing the facility to an outside entity. Other cities want to have more of a say in operations.
The organization that has failing depreciable equipment and has not funded depreciation can try to fund the replacement with a capital campaign or donations. Capital campaigns work for churches, universities, preschools, and charities, but capital campaigns to fund WRRFs haven’t been very successful in the past.

Funding depreciation from the beginning (or starting today) is a better choice.
 

Karl Birky is an environmental technician, and Erik Grimstad is a laboratory technician at the City of McMinnville (Ore.) Water Reclamation Facility.