Where does depreciation expense go on income statement

The accumulated depreciation account doesn't go on an income statement, but it indirectly relates to this financial data synopsis. Accounting regulations -- such as the United States Securities and Exchange Commission's guidelines -- tell companies how and where to report depreciation transactions, especially those pertaining to items like production equipment and computer hardware.

Depreciation

1. Depreciating an asset means gradually reducing its worth every year until the resource's value is zero or another amount that finance people call "salvage value." For example, a company buys production machinery valued at $100,000 and wants to depreciate it over five years. The corporate controller believes the machinery can fetch $20,000 at the end of its operating life -- this amount becomes the residual value or salvage value. As a result, the asset's depreciable base equals $80,000, or $100,000 minus $20,000. The annual depreciation expense amounts to $16,000, or $80,000 divided by 5.

Accumulated Depreciation

1. Accumulated depreciation is the total depreciation expense a business has applied to a fixed asset since its purchase. At the end of an asset's operating life, its accumulated depreciation equals the price the corporate owner originally paid -- assuming the resource's salvage value is zero. If not, accumulated depreciation equals the asset's book value minus its residual worth. "Fixed asset" is what finance people call a tangible asset, capital resource, physical asset or depreciable resource. Examples include buildings, computers and equipment.

Accounting and Reporting

1. To spread the cost of a capital asset, a corporate bookkeeper debits the depreciation expense account and credits the accumulated depreciation account. The last item is a contra-asset account that reduces the worth of the corresponding fixed resource. The accumulated depreciation lies right underneath the "property, plant and equipment" account in a statement of financial position, also known as a balance sheet or report on financial condition. Depreciation expense flows through an income statement, and this is where accumulated depreciation connects to a statement of profit and loss -- the other name for an income statement or P&L.

Income Statement

1. A statement of profit and loss provides a glimpse into revenues, expenses and net income. If you drill deeper in a company's income statement, you can figure out the tools and approaches the business uses to translate its economic power into competitive prominence. You primarily see that in its sales revenue, the diversity of its client base and the way department heads marshal company resources to expand market share and downgrade the attractiveness of rivals' products in customers' minds and hearts. The marketing function -- especially advertising and public relations -- takes care of the last scenario.

If you want to invest in a publicly-traded company, performing a robust analysis of its income statement can help you determine the company's financial performance.

There are many different terms and financial concepts incorporated into income statements. Two of these concepts—depreciation and amortization—can be somewhat confusing, but they are essentially used to account for decreasing value of assets over time. Specifically, amortization occurs when the depreciation of an intangible asset is split up over time, and depreciation occurs when a fixed asset loses value over time.

Depreciation Expense and Accumulated Depreciation

Depreciation expense is an income statement item. It is accounted for when companies record the loss in value of their fixed assets through depreciation. Physical assets, such as machines, equipment, or vehicles, degrade over time and reduce in value incrementally. Unlike other expenses, depreciation expenses are listed on income statements as a "non-cash" charge, indicating that no money was transferred when expenses were incurred.

Accumulated depreciation is recorded on the balance sheet. This item reflects the total depreciation charges taken to date on a specific asset as it drops in value due to wear and tear or obsolescence.

When depreciation expenses appear on an income statement, rather than reducing cash on the balance sheet, they are added to the accumulated depreciation account. Doing so lowers the carrying value of the relevant fixed assets.

Example: Depreciation Expense

For the past decade, Sherry’s Cotton Candy Company earned an annual profit of $10,000. One year, the business purchased a $7,500 cotton candy machine expected to last for five years. An investor who examines the cash flow might be discouraged to see that the business made just $2,500 ($10,000 profit minus $7,500 equipment expenses).

To counterpoint, Sherry’s accountants explain that the $7,500 machine expense must be allocated over the entire five-year period when the machine is expected to benefit the company. The cost each year then is $1,500 ($7,500 divided by five years).

Instead of realizing a large one-time expense for that year, the company subtracts $1,500 depreciation each year for the next five years and reports annual earnings of $8,500 ($10,000 profit minus $1,500). This calculation gives investors a more accurate representation of the company’s earning power.

But, this approach also presents a dilemma. Although the company reported earnings of $8,500, it still wrote a $7,500 check for the machine and has only $2,500 in the bank at the end of the year. If the machine generated no revenue for the next year, and the company's earnings were exactly the same, it would report the $1,500 depreciation on the income statement under depreciation expenses and reduce net income to $7,000 ($8,500 earnings minus $1,500 depreciation).

Example: Amortization

In a very busy year, Sherry's Cotton Candy Company acquired Milly's Muffins, a bakery reputed for its delicious confections. After the acquisition, the company added the value of Milly's baking equipment and other tangible assets to its balance sheet.

It also added the value of Milly's name-brand recognition, an intangible asset, as a balance sheet item called goodwill. Since the IRS allows for a 15-year period to use up goodwill, Sherry's accountants show 1/15 of the goodwill value from the acquisition as an amortization expense on the income statement each year until the asset is entirely consumed.

Accounting Entries and Real Profit

Some investors and analysts maintain that depreciation expenses should be added back into a company’s profits because it requires no immediate cash outlay. These analysts would suggest that Sherry was not really paying cash out at $1,500 a year. They would say that the company should have added the depreciation figures back into the $8,500 in reported earnings and valued the company based on the $10,000 figure.

Depreciation is a very real expense. In theory, depreciation attempts to match up profit with the expense it took to generate that profit. An investor who ignores the economic reality of depreciation expenses may easily overvalue a business, and his investment may suffer as a result.

Final Thoughts

Value investors and asset management companies sometimes acquire assets that have large upfront fixed expenses, resulting in hefty depreciation charges for assets that may not need a replacement for decades. This results in far higher profits than the income statement alone would appear to indicate. Firms like these often trade at high price-to-earnings ratios, price-earnings-growth (PEG) ratios, and dividend-adjusted PEG ratios, even though they are not overvalued.

Frequently Asked Questions (FAQs)

What is the difference between depreciation and amortization?

The main difference between depreciation and amortization is that depreciation deals with physical property while amortization is for intangible assets. Both are cost-recovery options for businesses that help deduct the costs of operation.

How do you calculate depreciation and amortization?

Calculating amortization and depreciation using the straight-line method is the most straightforward. You can calculate these amounts by dividing the initial cost of the asset by the lifetime of it.  

Why is depreciation an expense in the income statement?

Does depreciation affect income statement?