Are Depreciation and Amortization Operating Expenses?

Businesses incur various costs to operate and generate revenue. Among these costs are operating expenses, which reflect the regular expenditures of running a business. Separately, companies also account for the consumption of their long-term assets through processes known as depreciation and amortization. A common question arises regarding the classification of these latter two items: are depreciation and amortization considered operating expenses? This article clarifies the distinctions and relationships between these financial concepts, providing a clearer understanding for those navigating business financial statements.

Understanding Operating Expenses

Operating expenses represent the costs a business incurs from its normal, day-to-day activities to produce goods or services and generate revenue. These expenditures are essential for keeping the business operational. Examples of common operating expenses include salaries and wages for employees, rent for office or facility space, utility bills, marketing and advertising costs, and office supplies.

These expenses are short-term and consumed within the current accounting period. They reflect direct cash outflows from the business. The Internal Revenue Service (IRS) allows businesses to deduct these operating expenses, provided the business operates to earn profits.

Understanding Depreciation and Amortization

Depreciation and amortization are accounting methods used to allocate the cost of long-term assets over their estimated useful lives. While both serve a similar purpose of expense allocation, they apply to different types of assets. Depreciation specifically applies to tangible assets, which are physical items such as machinery, vehicles, buildings, and equipment. It reflects the gradual decrease in an asset’s value due to wear and tear, obsolescence, or usage over time.

Amortization applies to intangible assets, which are non-physical assets like patents, copyrights, trademarks, and software licenses. Like depreciation, amortization spreads the cost of these assets over the period they provide economic benefit. Both depreciation and amortization are non-cash expenses; they do not involve an immediate cash outflow when recorded. Instead, the cash outflow occurred when the asset was initially purchased, and these expenses are accounting entries designed to match the asset’s cost with the revenue it helps generate over its useful life.

The Relationship Between Depreciation, Amortization, and Operating Expenses

Under generally accepted accounting principles (GAAP), depreciation and amortization are classified as operating expenses on a company’s income statement. They are considered necessary costs of doing business, reflecting the consumption of assets used in core operations to generate revenue. For instance, the depreciation of manufacturing equipment directly involved in production or office buildings supporting administrative functions falls under operating expenses.

These expenses appear within the operating expenses section of the income statement, sometimes as a separate line item or embedded within cost of goods sold (COGS) or selling, general, and administrative (SG&A) expenses. For example, depreciation on factory machinery would be part of COGS, while depreciation on office equipment would be part of SG&A. Despite their non-cash nature, they reduce a company’s net income. When analyzing cash flow from operations, these non-cash expenses are added back to net income, which is why metrics like Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) are used.

Why This Classification Matters

Classifying depreciation and amortization as operating expenses has several implications for financial reporting and analysis. For financial reporting, including these expenses directly impacts a company’s reported net income and profitability metrics. They reduce taxable income, thereby lowering a company’s tax liability.

For financial analysis, understanding this classification is important when evaluating a company’s performance. Analysts and investors adjust for depreciation and amortization, by looking at cash flow from operations or metrics like EBITDA. This allows for a clearer comparison of operational performance between companies with differing levels of capital investment. Internally, management relies on this classification to understand the true cost of asset utilization, informing decisions about asset replacement, maintenance, and future capital expenditures.