Depreciation as an Operating Expense for Small Business
Depreciation can be tricky to classify. For small business owners, knowing when it counts as an operating expense improves financial clarity and supports better tax planning.
What Counts as an Operating Expense?
Operating expenses are the costs your business incurs through normal business operations. These include rent, utilities, insurance, inventory costs, wages, and administrative expenses.
If the expense is necessary to keep your business running and generate revenue, it's considered an operating expense. These are reported on your income statement and are used to determine your operating profit.
Operating expenses can be fixed, like monthly lease payments, or variable, such as packing and shipping tied to your sales volume.
How Depreciation Works as an Expense
Depreciation spreads out the cost of a fixed asset over its useful life. This reflects wear and tear on long-term property like equipment or vehicles. Although it doesn't involve cash, it's deductible and reduces your taxable income.
Depreciation appears on your income statement as a non-cash expense and lowers the book value of the asset on the balance sheet.
When Is Depreciation an Operating Expense?
Depreciation is considered an operating expense when the asset supports core business functions. If equipment is used to produce goods or deliver services, its depreciation counts as part of your operating costs.
It is a non-operating expense when the asset isn't tied to your core business activities. This includes assets used for side activities, long-term investments, or rarely used property. Depreciation in these cases is reported separately to clarify operational performance.
Examples of Operating vs Non-Operating Depreciation
Here are some examples to show how depreciation is recorded based on the role an asset plays in the business. A professional in accounting services for small businesses can help you classify operating and non-operating depreciation expenses correctly in your own business.
Restaurant Example
A restaurant in Jacksonville, FL, uses kitchen equipment daily for food preparation. It also owns a delivery van used once or twice a month for catering gigs.
Operating Expense: The depreciation of the kitchen equipment counts as an operating expense because it supports core activities like daily food prep and service.
Non-Operating Expense: The depreciation on the delivery van is a non-operating expense because occasional catering isn't part of the restaurant's primary operations.
Marketing Agency Example
A small marketing agency uses computers and software daily to manage client campaigns. It also owns a company car mainly for personal errands and occasionally to visit clients.
Operating Expense: The depreciation of the computers and software counts as an operating expense. They are essential tools to deliver the agency's core service.
Non-Operating Expense: The depreciation of the company car is a non-operating expense since it's mostly used for personal purposes and only rarely supports business activities. The depreciation of the personal-use portion of the car cannot be claimed as a tax deduction.
Manufacturing Company Example
A manufacturing company uses heavy machinery on its production line daily. It also owns a forklift that is mostly idle and only used occasionally for moving inventory in the warehouse.
Operating Expense: The depreciation of the production machinery counts as an operating expense. It directly supports the manufacturing process and is included in the costs of goods sold (COGS).
Non-Operating Expense: The depreciation of the forklift is a non-operating expense since it's not regularly used in production and only supports incidental warehouse activities.
How Depreciation Affects Financial Statements
Depreciation appears on three major financial statements and impacts how your business performance is measured.
Income Statement: Depreciation is listed as an expense that reduces the net income. It may appear as a single line item or be included in operating costs and cost of goods sold (COGS).
Balance Sheet: Accumulated depreciation appears as a contra asset that reduces the book value of fixed assets.
Cash Flow Statement: Depreciation is added back under operating activities because it doesn't affect cash, helping show your true cash flow.
Tracking depreciation correctly helps show the actual costs of using long-term assets over time.
Separating Depreciation in COGS
Companies often separate depreciation related to production equipment from other operating expenses. This allows them to include only the portion tied to making products in the cost of goods sold (COGS). It shows how much it costs to produce inventory.
Separating depreciation also improves gross profit calculations by ensuring only production-related expenses are included. For small businesses, this helps identify depreciable assets that directly impact product costs. It supports accurate pricing, margin control, and confident tax preparation.
Depreciation classification and cost allocation can become complex quickly. Many small business owners rely on accounting professionals to handle these details correctly. This helps avoid costly errors and ensures accurate financial reporting.
Why Depreciation Classification Matters
Accurate depreciation reporting keeps your financials clean and useful. It ensures expenses reflect how assets are actually used.
Impacts operating income and profit margins. Operating income is your revenue minus operating expenses. When depreciation is classified as an operating expense, it lowers your operating income. That directly affects how your core profitability is measured and reported.
Influences financial analysis and valuation. Key financial ratios, like return on assets or operating margin, depend on accurate expense classification. Misreporting depreciation will distort these metrics, potentially leading to misleading conclusions for lenders, investors, or buyers.
Affects EBITDA calculations. Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) is a non-GAAP metric often used to measure operating performance without the effects of financing and non-cash expenses. Because depreciation is added back in this calculation, misclassifying it will skew how profitable your business appears.
How Depreciation Is Reported for Tax Purposes
The IRS allows businesses to deduct depreciation on operational assets used, even though it's a non-cash expense. For tax purposes, it's reported separately from operating costs to show how much of your deduction comes from capital assets.
Most businesses use the Modified Accelerated Cost Recovery System (MACRS) to calculate depreciation. Others choose straight-line depreciation for simplicity or strategic planning. Choosing the right method and classifying operational assets correctly impacts your deductions, income taxes, and long-term tax strategy.
Schedule a consultation with our tax professionals to ensure you're using the best depreciation strategy for your business.
Clearing Up Misconceptions About Depreciation
Many small business owners misunderstand how depreciation works. Let's clear up a few common myths.
"Depreciation isn't a real expense."
Depreciation is a real expense that reduces your taxable income even if it doesn't involve cash leaving your bank account. Ignoring it gives an inaccurate picture of your profit.
"Depreciation reduces cash flow."
Depreciation is a non-cash expense and doesn't affect your cash flow. It affects your income statement, not your bank balance. That's why it's added back on the cash flow statement under operating activities.
"Only big companies need to track depreciation."
All businesses need to track depreciation. It helps with tax deductions, budgeting for equipment replacements, and understanding long-term costs.
Example: Depreciation in Action
A small business owner buys a delivery van for $10,000 to support daily operations.
The van is depreciated over five years using the straight-line method. Each year, $2,000 is reported as a depreciation expense on the income statement. This reduces operating profit but doesn't affect cash flow.
Income Statement
This is how the depreciation would appear on the income statement.
ExampleCo Retail
For the Year Ended December 31, 2024
|
Revenue |
$100,000 |
|
Operating Expenses |
|
|
Salaries |
$40,000 |
|
Rent |
$12,000 |
|
Depreciation (Van) |
$2,000 |
|
Total Operating Expenses |
$54,000 |
|
Operating Profit |
$46,000 |
Balance Sheet
The van is listed as a $10,000 asset on the balance sheet. Accumulated depreciation increases by $2,000 each year. This reduces the van's book value over time.
This is how it would appear on the balance sheet at the end of the first year.
|
Assets |
Amount |
|
Fixed Assets (Van) |
$10,000 |
|
Less: Accumulated Depreciation |
($2,000) |
|
Net Book Value of Van |
$8,000 |
Cash Flow Statement
The $2,000 depreciation is added back under operating activities on the cash flow statement. Since it's a non-cash expense, this adjustment keeps the cash flow statement aligned with real cash activity.
This is where it would appear on a cash flow statement.
|
Operating Activities |
|
|
Net Income |
$46,000 |
|
Add Back Non-Cash Expense: Depreciation |
$2,000 |
|
Net Cash from Operating Activities |
$48,000 |
Depreciation’s Role in Clear Financial Reporting
Depreciation is essential for accurately tracking costs, reporting income, and planning business finances. Correct classification of depreciation ensures your financial statements reflect real operations and provide reliable data for lenders, investors, and tax professionals.
Small businesses need clear, accurate reporting to support pricing, budgeting, and tax planning. If you're unsure about your depreciation methods or classifications, consult a tax professional to align your accounting with your business goals.
