The short answer? Yes, depreciation is an operating expense. Companies often buy fixed assets for their company, but these assets don’t last forever. That means that each year the asset is used it loses value. The company capitalizes these assets and depreciates the balance over the years that the asset is used, also known as its useful life. These words may not mean much yet, but keep reading to fully understand the question.
What is Depreciation?
To dig into our main question, we first need to understand what depreciation is. When something depreciates, it loses value. This is a tangible value reduction, such as a car getting older, or property being sold for less than it was first bought. More specifically, depreciation is an accounting method used to find, or allocate, a place for the cost of a tangible asset over the life of that asset (useful-life), and then used to keep track of the asset’s loss of value.
Buildings, machines, computers, furniture, and other equipment are all examples of tangible assets that last more than one year and can depreciate. During each accounting period, a part of those assets are going to be used up. For example, if you buy a $10,000 truck for your lawn-mowing business it may last you for a total of seven years but each year the truck is going to be worth less. The number of years your company depreciates an asset is called useful life. The IRS uses a system called the Modified Accelerated Cost Recovery System (MACRS) to set the useful life for different types of assets.
The great thing about depreciation is that you can write it off in your taxes, but instead of doing it all in one tax year, you write off parts of it over time—giving you more control over your finances.
Methods of Depreciation
There are many ways to depreciate an asset. The one your company chooses will determine how much you write off each year. The most common types of depreciation are:
- Straight-line Depreciation
- Double Declining Balance
- Sum-of-Year’s Digits
- Units of Production
These names don’t do much to explain how they work but don’t worry, it’ll make more sense when you understand the method.
Straight-line is the most simple and common form of depreciation. It assumes the depreciation expense is the same for each year that the asset is in use, so the depreciation amount is the same each year of its useful life.
Straight-line = (Cost – Salvage value) / Useful life
Double-Declining Balance & Sum of Year’s Digits
The double-declining balance method and sum-of-year’s digits (SYD) method both let you write off more of an asset’s value in early years and less in the years later on. This comes from the fact that some assets are more productive when first bought.
Double declining balance = Straight-line Depreciation Rate x 2
Sum-of-year’s digits (SYD) = (Remaining life / Sum of the years digits) x (Cost – Salvage value)
Units of Production
With the units of production method, the amount you write off each year depends on how frequently the asset was used. This depreciation method deals with equipment and how many units can come from it during its useful life. For example, if you own a bakery, how many cookies (units) will your oven be able to produce before it stops working? How many units will it produce this year?
Units of production =(Number of units produced / Life in number of units) x (Cost – Salvage value)
To use any of these depreciation methods you’ll need to know the total price you paid for the asset, how much you can sell it for (salvage value), and it’s useful life.
So, What Can You Depreciate?
The IRS has guidelines for the type of assets your company can depreciate. They must meet these criteria:
- It must be used in your business to provide income.
- It must last for more than one year.
- You must own it.
- Its useful life can be determined.
After checking that your asset can be depreciated and calculating the depreciation expense, the next step is documenting the expense. The journal entry for depreciating your assets is a debit to an expense account in the income statement and a credit to accumulated depreciation in the balance sheet.
Why is Depreciation Important?
It is important because depreciation expense represents the use of assets in each accounting period. Companies use depreciation to report asset use to stakeholders. Stakeholders can look at the information and know when to expect replacement assets.
Your company may also see tax benefits from depreciation. Tax rules let depreciation expenses be used as a tax reduction against revenue. The higher the depreciation expense is, the lower the taxable income is—meaning more tax savings.
What are Operating Expenses?
The final step in understanding our question is to understand what an operating expense is. An operating expense is an expense that a business incurs regularly in its day-to-day functions. Operating expenses are not directly associated with production, unlike cost of goods sold, which mainly deal with the direct costs of producing a product.
Operating costs may include:
- Office supplies
- Legal fees
- Accounting fees
- Travel costs
Keeping a close eye on these expenses is important because they speak to the core needs of your business to run well. But does depreciation fit among them?
The Final Verdict
Now that we have all of the background information we need on depreciation and operating expenses, we can answer our headlining question.
Since an operating expense is incurred from normal business operations and a depreciated asset is part of normal business operations, depreciation is considered an operating expense.
Depreciation can be tricky at first, but it doesn’t have to be. If you need help keeping up with your depreciation expenses, ScaleFactor’s automated accounting software can help.