Is Depreciation an Expense?

Q:

Is depreciation an expense?

A:

To give a short answer, depreciation is an operating expense. Keep reading for an explanation.

When a company purchases an asset such as equipment or a building, it is capitalized. This means that the purchase is not recognized as an expense on the income statement, but rather as an asset on the balance sheet. Keep in mind that not all assets purchased can be capitalized. Capitalization is typically reserved for assets that are able to provide the company with a benefit for normal operations that extends into the future (beyond a year). Generally, capitalization pertains to the costly purchases made by a business such as buildings, equipment, and vehicles that will last for several years.

When a business capitalizes a purchase, this does not mean that it will never realize an expense. This is where depreciation comes into play. Depreciation is used to gradually expense an asset that has been capitalized. For example, a company will use the depreciation expense to spread the cost of a piece of equipment over its useful life. The most commonly used method to depreciate an asset is through straight-line depreciation.

Depreciation is an operating expense that appears on the income statement. As an expense, it reduces taxable income reported by a business. However, keep in mind that depreciation is a non-cash expense. This means that the depreciation expense does not directly impact a company’s cash. How can this be? Well, the payment for a depreciated asset is made when the asset is acquired.

For example, a business might purchase a buildings and pay cash.  The cash payment is recognized when the building is purchased, which will reduce the company’s cash at this time. The depreciation expense accounted for over the useful life of the building will not require cash to be spent since the building was initially paid for in cash.

Depreciation does indirectly affect net income since it reduces taxable income. A decrease in taxable income typically means a company will have a lower tax payment. This means that a business will not have to pay as much cash to the government for taxes, which will have a positive impact on cash flow.