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An Appreciation for Depreciation

What is depreciation?

Depreciation is defined as a reduction in value of an asset with the passage of time, due in particular to wear and tear. It is also an accounting method of allocating the cost of a tangible or physical asset over its useful life or life expectancy and sometimes represents how much of an asset’s value has been used up.

For those communities that perform an external audit, depreciation calculations are a required component. Generally, this calculation is an accounting of the remaining value of a capital asset when accounting for the life of the asset, original cost, and years since the construction or purchase of the asset. This number is used by funders (such as Bond Bank) in evaluating an applicant’s credit strength as high ratios of accumulated depreciation to original cost may indicate a need for debt financing to overcome the backlog.

For communities that do not perform an external audit, they can track assets using straight line depreciation on a simple spreadsheet using the methods described above. In both cases, the purpose is to represent the original and remaining value of capital assets with the value serving as a proxy for future investment needs within a community.

How does depreciation get funded?

A community may ‘fund’ depreciation by adding the annual calculated value to the approved budget as an expense. If truly funded, at the end of the year, the account would have at least that line item’s amount left over. For example, if a budget had $15,000 in depreciation as a line item, there should be at least $15,000 left unexpended in the budget at the end of the year, assuming rates/taxes were established to reflect the total amount of revenue, including depreciation, that was needed. This amount would then be counted toward a reserve fund or held in the account as cash. The issue most budgets run into is there is not $15,000 left over at the end of the year, meaning that other line items were over expended or anticipated revenue was down. 

So, is that it, we just fund depreciation for future capital spending?

No! Using depreciation as a proxy for future capital needs can be a good start in establishing reserves, but it certainly isn’t nor should it be the only way a community calculates and saves. There are some inherent challenges with only relying on depreciation as the foundation of capital reserves not the least of which is depreciation doesn’t take into consideration inflation, as the cost to purchase and install said asset will almost certainly increase but the amount that is depreciated remains the same.

There are myriad ways to fund infrastructure investment, both through saving and borrowing. See other articles Bond Bank has published including Asset Prioritization in an Economic Downturn or Paying for Infrastructure or Funding v. Financing

How can a community evaluate if it is on track with investing in their infrastructure?

One metric a community can use to evaluate how well they are investing is to calculate their Capital Asset Depreciation ratio. This is the ratio of Accumulated Depreciation to Gross Depreciable Assets, excluding land and construction in progress. Both of these numbers can be found in the annual audit. The closer to 1.0 or 100% the closer the assets are to being fully depreciated. In fact, much above 60-65% means a community needs to be actively evaluating in their assets and could indicate necessary investment is imminent.

Of course, there are other metrics that can be used. Examining how much is being spent on routine maintenance or emergency repairs over time can be used to gauge how an asset is aging and if it might be time to reinvest. Asset management is another good tool. And while less quantitative, using public feedback or good old ‘boots on the ground’ are other tools at a community’s disposal.