Should Depreciation Be Included in Operating Expenses?

Depreciation is a common accounting term that often raises questions regarding its classification within a company’s financial statements. Understanding its accounting treatment and significance is essential for assessing a business’s financial health.

Understanding Depreciation

Depreciation allocates the cost of tangible assets over their useful lives. Instead of expensing the entire cost of a large asset, like machinery or a building, in the year it is purchased, depreciation spreads this cost over the years the asset is expected to generate revenue. This accounts for the asset’s gradual wear, obsolescence, or consumption.

This process aligns with the accounting matching principle: expenses should be recognized in the same period as the revenues they help generate. For example, a delivery truck’s cost is recognized each year it is used, matching the expense with the revenue it helps produce. This provides a more accurate picture of financial performance over time.

Depreciation is a non-cash expense. While it reduces reported profit on the income statement, it does not involve an actual cash outflow in the period it is recorded. The cash outflow for the asset occurred when it was initially purchased.

Calculating depreciation involves estimating an asset’s useful life and its salvage value. Useful life is the period the asset is expected to be productive. Salvage value is the estimated residual value at the end of its useful life. These estimates determine the annual depreciation expense.

Understanding Operating Expenses

Operating expenses, or “OpEx,” are costs a business incurs in its normal, day-to-day operations to generate revenue. These are distinct from the direct costs of producing goods or services, known as the cost of goods sold (COGS).

Examples include salaries, rent, utilities, marketing, office supplies, and maintenance. These expenses are incurred to support the core commercial functions of the business.

Operating expenses are recorded on the income statement, typically below gross profit. They are directly tied to a company’s operational efficiency. Most operating expenses involve a direct cash outflow.

Non-operating expenses are costs not directly related to core business activities, such as interest expense or losses from asset sales. They are reported separately on the income statement to provide a clearer picture of a company’s core operational performance.

Depreciation’s Role in Operating Expenses

Depreciation is classified as an operating expense when the asset is integral to core business operations. This applies to assets like manufacturing machinery, office equipment, or vehicles supporting daily functions. Its inclusion reflects the ongoing cost of using these assets to generate revenue.

This classification adheres to the matching principle. The cost of using an asset to produce revenue is recognized in the same period that revenue is earned. Depreciation systematically allocates the initial cost of a long-term asset over its useful life, matching a portion of that cost with revenues.

On the income statement, depreciation appears within or alongside other operating expenses, such as selling, general, and administrative (SG&A) expenses. Its presence reduces reported operating income and, consequently, net income. This helps financial statements accurately reflect the true cost of operations.

While depreciation is an operating expense, it is a non-cash expense. Unlike salaries or rent, no cash changes hands when the expense is recorded. The cash outflow occurred when the asset was acquired. This non-cash nature differentiates it from most other operating costs.

Practical Implications of Depreciation’s Classification

Understanding depreciation as a non-cash operating expense has important practical implications for financial analysis. While it reduces reported net income, it does not directly affect immediate cash flow from operations. The cash was spent when the asset was purchased.

Because depreciation lowers taxable income, it can indirectly reduce a company’s cash outflow for taxes, positively impacting cash flow. This tax benefit is a significant advantage for businesses.

On cash flow statements using the indirect method, depreciation is added back to net income to arrive at cash flow from operating activities. This acknowledges it as a non-cash item that reduced profit but not cash.

Financial analysts and business owners often use Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) to view operational performance. EBITDA removes the effects of financing, tax strategies, and non-cash entries like depreciation. This provides a standardized measure of core operational profitability, useful for comparing companies across different industries or with varying capital structures.

Differentiating between cash and non-cash operating expenses is important for evaluating a company’s cash-generating ability. A company might report low net income due to high depreciation, yet still have strong cash flow from operations. This distinction helps assess liquidity and financial health more comprehensively.