How Depreciation Expense Appears in the Income Statement

Depreciation expense is the systematic allocation of the cost of property, plant, and equipment (PP&E) over its useful life. It reflects the consumption of economic benefits embodied in long-lived assets and ensures that expenses are matched with the revenues they help generate. Depreciation is a non-cash expense, but it has a significant impact on profitability, tax obligations, and performance ratios. Its reporting in the income statement links directly to the valuation of PP&E on the balance sheet.

Depreciation represents the gradual consumption of fixed assets.

When a company acquires a long-term asset such as machinery, vehicles, or buildings, the cost cannot be expensed immediately, because the asset will benefit multiple reporting periods. Instead, the expense is spread systematically across the asset’s useful life. Depreciation does not reflect a cash outflow but rather the recognition that assets lose value through use, wear and tear, or obsolescence.

For example, machinery costing 100,000 with a 10-year useful life and no residual value is depreciated at 10,000 annually under the straight-line method. Each year, this expense reduces reported income while the carrying value of the asset declines.

Presentation in the income statement depends on function.

Depreciation expense is reported within operating expenses in the income statement. Depending on the classification approach, it may appear in different sections:

• By function: Depreciation is included in cost of goods sold, selling expenses, or administrative expenses, depending on how the asset is used.

• By nature: Depreciation is presented as a separate line item, labeled “Depreciation and Amortization.”

For example:

Item	Amount (USD)
Revenue	500,000
Cost of Goods Sold	300,000
Gross Profit	200,000
Depreciation Expense	20,000
Other Operating Expenses	100,000
Operating Income	80,000

This format highlights depreciation’s impact on operating income.

Journal entries demonstrate depreciation recognition.

At year-end, depreciation is recorded through:

• Debit: Depreciation Expense 20,000

• Credit: Accumulated Depreciation 20,000

The expense reduces profit in the income statement, while accumulated depreciation is a contra-asset account offsetting PP&E in the balance sheet. This dual effect aligns expense recognition with asset valuation.

Standards guide the method and disclosure of depreciation.

Both IAS 16 under IFRS and ASC 360 under US GAAP require that depreciation be based on the asset’s cost, estimated useful life, and residual value. Companies must review useful lives and methods regularly to ensure accuracy. Common methods include:

• Straight-line: Equal expense each period.

• Declining balance: Higher expense in earlier years.

• Units of production: Expense based on usage or output.

For example, under units of production, if equipment is expected to produce 100,000 units over its life and produces 15,000 units in the first year, 15 percent of cost is depreciated in that year.

Depreciation impacts profitability and taxation.

Although depreciation does not involve cash, it reduces taxable income in jurisdictions where tax authorities accept accounting depreciation or a modified version. This provides a tax shield effect, lowering cash taxes paid. Analysts often add depreciation back when calculating cash flow from operations, recognizing its non-cash nature.

For instance, EBITDA (earnings before interest, taxes, depreciation, and amortization) excludes depreciation, providing a measure of operating performance unaffected by accounting choices for long-term assets.

Disclosures provide transparency about depreciation policies.

Companies must disclose in the notes:

• Depreciation methods used.

• Useful lives or rates applied.

• The gross carrying amount of PP&E and accumulated depreciation.

• Total depreciation expense recognized during the period.

Such disclosures allow stakeholders to understand how aggressively or conservatively a company depreciates its assets and to compare practices across entities.

Depreciation expense connects income and balance sheet reporting.

Depreciation ensures that the cost of long-lived assets is allocated across the periods that benefit from their use. Its presence in the income statement reduces reported income, while its accumulation on the balance sheet reduces the carrying value of PP&E. This dual role makes depreciation central to both financial performance and position, balancing accurate profit measurement with faithful representation of asset values.

____________

FOLLOW US FOR MORE.

DATA STUDIOS

datastudios.org