Of course, major purchases such as equipment most definitely are major costs to your organization! The short story is that it does show up as an expense. The longer story involves explaining how that happens.
Accounting makes a distinction between day-to-day operational costs – treated as expenses – and major purchases – treated as capital assets.
Anything treated as an expense is of minor value, and is generally consumed within a year. By contrast, capital assets (also known as fixed assets) cost a significant amount of money, last longer than a year, and are instrumental in carrying out your daily operations.
Buildings and equipment are the most typical examples. Major renovations (as opposed to maintenance work) are also treated as capital assets. Computer software and websites may also be capitalized, depending on their scope.
When an item is capitalized, the purchase cost is recorded in the assets section of the balance sheet. It moves gradually into the expense stream over a period of years, through the mechanism of depreciation (also known as amortization).
A key aspect of managing capital assets is estimating their useful life. Computers and other office equipment are often estimated to last five years. Vehicles are often depreciated over five years, office furniture and fixtures over seven years, and buildings over 40 years. These may be common periods, but you and your accountant need to discuss what makes sense for your organization and its belongings.
Once you’ve estimated useful life, you and your accountant need to select a method of depreciation. The simplest – and one that is commonly used in the not-for-profit sector – is straight-line depreciation.
If you estimate that you’re going to get five years out of your computer before you need to replace it, you divide the purchase cost by five. This year, you will see one-fifth of the cost of the computer in your expenses – and the same over the next four years.
Why is it done this way? An intuitive way to grab hold of the accounting theory might be to imagine it as a question of fairness. It wouldn’t be fair to charge this year’s bottom line with the full burden of a five-year purchase. Nor would it be fair to give the next four years a “free ride” in terms of computer cost. Depreciation allows the price of the computer to be spread fairly over the years of ownership.
