IAS 16 defines depreciation as the systematic allocation of the depreciable amount of an asset over its useful life. The depreciable amount equals the purchase cost of the asset less the salvage value or other amount like the revaluation amount of the asset. Depreciation amounts to distributing the cost of assets to the income statement over the asset’s useful life.
Depreciation is a non-cash operating activity resulting from qualitative wear and tear in the use of assets. Still, it has been quantified by using accounting principles and assumptions in line with the enterprise’s own accounting policies.
The amount of depreciation needs to be calculated each year and is debited to Income Statement like any other operating expense. Depreciation cumulatively rises over time and hits the cost less salvage value in the final year of useful life.
This accumulated depreciation reduces the historical value of the asset to arrive at the written-down value of the asset. Written down value is computed after charging depreciation accumulated over the years to the initial cost, i.e., historical cost.
Depreciation is computed using various methods as a straight-line method, double declining method, units of production, and the sum of years digits method.
Operating expenses are normal business expenditures incurred daily. The operating expenses are incurred during the daily works of business operations. These expenses are, however, not directly associated with the production of goods or services. Examples of operating expenses include the following:
- Insurance costs
- Legal fees
- Office supplies
- Compensation and related payroll tax expenses
- Advertising costs
- Entertainment costs
- Rent of production facilities
Basically, there are two operating expenses viz administrative operating expenses and sales and marketing-related operating expenses.
The administrative expenses relate to office-related expenses like legal fees and printing and stationery. Sales and marketing-related operating expenses include advertising costs, travel costs, amongst others.
Is depreciation operating expense?
Depreciation replicates the period and scheduled conversion for a fixed asset into an expense as the asset is used during normal business operations. As the assets are used to generate operating income in the normal course of business, depreciation expense is considered an operating expense.
Depreciation depicts the scheduled conversion of the purchase cost and other associated costs into the expense during its useful life during the normal course of business operations.
Depreciation is, however, one of those operating expenses where cash movement is lacking. This is because the cash was already incurred for acquiring the asset, and hence there is no requirement of spending the cash unless up-gradation of the asset is required.
Therefore, depreciation is a non-cash component of operating expenses. The same treatment goes for the amortization of intangible assets.
Another way to look at it is to assume that all the business’s fixed assets will ultimately be replaced, in which case large cash outflow would be required for replacement assets. From this angle, there is a better view to identifying the relationship between cash flow and the amount of depreciation.
Hence, depreciation will not be considered as part of operating expenses in the short term. Still, it should be considered an operating expense to provide for replacement cycles in the long term.