Where Does Depreciation Expense Go on the Income Statement?

An income statement serves as a financial report, providing a snapshot of a company’s financial performance over a specific period, such as a quarter or a year. This statement details revenues earned and expenses incurred, ultimately arriving at the company’s net income or loss. Among the various expenses listed, depreciation expense is a common and often significant item that impacts a company’s reported profitability. Understanding where depreciation expense is located on the income statement is important for anyone seeking to comprehend a company’s financial health and operational efficiency.

Understanding Depreciation Expense

Depreciation expense represents the systematic allocation of the cost of a tangible asset over its estimated useful life. This accounting practice recognizes that assets like buildings, machinery, vehicles, and equipment lose value and utility over time due to wear, obsolescence, or usage. It is considered a non-cash expense, meaning it does not involve an actual cash outflow in the period it is recorded. The primary purpose of recording depreciation is to match the expense of using an asset with the revenues that the asset helps to generate.

This matching principle is fundamental to accrual accounting, ensuring that financial statements accurately reflect a business’s economic performance. By spreading the asset’s cost over its useful life, depreciation provides a more accurate picture of profitability each period. It is also important for proper financial reporting and reflects the gradual consumption of an asset’s economic benefits.

Placement on the Income Statement

The placement of depreciation expense on the income statement depends on the asset’s function within business operations. This distinction helps understand operational costs and profitability. The general principle is to classify depreciation with the activities it supports.

Depreciation related to administrative assets, such as office buildings and furniture, is reported as part of “Operating Expenses.” This category includes selling, general, and administrative (SG&A) expenses. Depreciation on assets used for selling activities, like delivery vehicles, also falls under operating expenses. These costs are incurred to run the company but are not directly tied to production.

Conversely, depreciation on assets directly involved in the manufacturing or production process is included within the “Cost of Goods Sold” (COGS). This applies to factory machinery and production equipment. Including these costs in COGS ensures all expenses directly associated with creating products sold are accounted for before calculating gross profit.

While less common, depreciation on assets not related to a company’s primary activities might appear under “Other Income and Expenses.” This category handles non-operating items. However, for most businesses, depreciation is found within operating expenses or as part of the cost of goods sold, reflecting its direct link to administrative/selling functions or production.

Impact on Reported Profitability

The inclusion and placement of depreciation expense significantly influence the profitability metrics reported on the income statement. Its treatment directly affects how investors and analysts perceive a company’s financial performance. Because depreciation is an expense, it systematically reduces reported profits at various stages of the income statement.

When depreciation is included in the Cost of Goods Sold, it directly reduces a company’s gross profit. Gross profit is calculated by subtracting COGS from total revenue, and a higher COGS due to depreciation will result in a lower gross profit. This impacts the perceived profitability of a company’s core product sales.

Regardless of whether it is allocated to COGS or operating expenses, depreciation ultimately reduces operating income. Operating income, also known as Earnings Before Interest and Taxes (EBIT), is derived by subtracting all operating expenses (including COGS and SG&A) from revenue. By reducing operating income, depreciation provides a more accurate reflection of the profitability of a company’s primary business operations before considering financing costs or taxes.

Finally, as an expense recorded on the income statement, depreciation contributes to the reduction of net income. A lower net income impacts earnings per share and the amount of retained earnings available for reinvestment or distribution.