What is Depreciation?

Depreciation is the periodic, scheduled conversion of a fixed asset into an expense as the asset is used during normal business operations. Depreciation is intended to reduce the carrying amount of a fixed asset to its estimated salvage value over the course of its useful life at a steady rate. This is a non-cash expense, since the holder of the asset already expended the necessary funds to acquire the underlying fixed asset.

What is an Operating Expense?

An operating expense is any expense incurred as part of normal business operations. The operating revenues of a business, minus its operating expenses results in the gain or loss from its core operations, which is the essential performance metric that managers and investors review.

Is Depreciation an Operating Expense?

Since the assets being depreciated are part of normal business operations, depreciation is considered an operating expense. However, depreciation is one of the few expenses for which there is no associated outgoing cash flow. The reason is that cash was expended during the acquisition of the underlying fixed asset; there is no further need to expend cash as part of the depreciation process, unless it is expended to upgrade the asset. Thus, depreciation is a non-cash component of operating expenses (as is also the case with amortization).

If a business has a large fixed asset investment, this means that the non-cash depreciation portion of its operating expenses can greatly overstate the amount of month-to-month cash outflow actually being caused by company operations.

Another way of looking at the situation is to assume that all fixed assets must eventually be replaced, in which case depreciation is simply masking a large, infrequent cash outflow to pay for a replacement asset. From this perspective, there is (eventually) a relationship between cash outflow and the amount of depreciation recognized as operating expense. Therefore, depreciation should not be considered a cash component of operating expenses in the short term, but it should be considered one over a period long enough to encompass equipment replacement cycles.