Yes, depreciation is an operating expense when you use the asset you’re depreciating for your core business operations according to Generally Accepted Accounting Principles (GAAP). Your core business is how you regularly generate revenue as opposed to other activities that create revenue on the side or sporadically.
Depreciation can be a non-operating expense when the asset is not related to your core business. Examples include:
- A cyber-security company buying a beach house as an investment.
- An agricultural producer buying a logistics company where they shut down the transportation unit but keep the warehouse unit. The trucks from the now closed transportation unit would sit idle until sold, but the company would still expense depreciation as a non-operating expense.
Large companies separate depreciation expenses directly related to cost of goods sold (COGS) from other depreciation expenses, while small businesses may lump all depreciation expenses together at tax time if they meet the small business taxpayer exemptions.
Even if your small business meets the small business exemption, separating depreciation expense by operating activity (like a larger corporation does) may benefit your business.
The Benefits of Separating Depreciation Expense by Operating Activity
Separating depreciation expenses by operating activity is good practice because it can help you run a more profitable business, by giving you deeper insight into your cost of goods sold (COGS) and making your business more appealing to lenders. Separating by operating activity means that, instead of combining all depreciation expenses for your business into a single line item, you allocate the expenses based on where they are used in operations:
- COGS—depreciation for machines and buildings used in your production of goods
- R&D—for equipment and facilities used for research and development activities
- SG&A—for offices, equipment, and other assets used for sales and general administration
- Other depreciation—for other assets not included in the above categories (check with your tax professional if you think an asset fits here.)
Breaking out depreciation expenses into these activities instead of using a single line provides a clearer picture of your business operations. This will help you run a more profitable business and also make your business look more professional to third parties like lenders.
Separating depreciation expenses for accurate COGS
Tracking the depreciation expenses for machines, buildings, depreciating materials, and other items related to manufacturing separately from the depreciation for other assets lets you calculate more accurate COGS, to help improve profitability. With accurate COGS, you’ll be able to better determine:
- If increasing or decreasing prices will generate more profit.
- Whether you can or should give volume discounts.
- Which growth options work based on your company’s specific expenses.
- How to prioritize cost-cutting efforts.
- Who the best customers are and how to target them better.
Making your business more appealing to lenders
Separating depreciation expenses by operating activity makes you a more appealing borrower because your company will stand out from others on 3 of the “6 C’s of credit.” This is a standard list of elements lenders use when evaluating whether to approve you for a small business loan. The 3 of note here include:
- Character: You’ll demonstrate command of your business with precise financial statements that give the lender confidence in your financial knowledge and your ability to execute operations.
- Conditions: Allocating depreciation to COGS lets you present a more thorough break-even analysis for equipment financing or inventory loans because you’ll have more accurate costs for the analysis.
- Capacity: More accurate COGS (including depreciation) helps you run a more profitable business. This can get you better terms on loans because you’ll have a greater capacity to repay the financing.
Allocating depreciation across operating expenses can also improve your chances of loan approval by separating the effect of “true operating activities” from tax decisions like Section 179 elections or bonus depreciation.
Both of these lower your income and profit margin for the year vs. standard depreciation, which is applied over multiple years. A lender might not approve a loan if they focus on the year-over-year decline in profit without realizing it’s the result of a tax decision that doesn’t reflect your true cash flow.
You can avoid this problem by giving your lender detailed financial reports that clearly show depreciation expenses for each business activity on your income statement. Then, explain how your tax choices affect your cash flow statement.
In almost all cases, depreciation is an expense related to running your business. Tracking depreciation for each specific part of your business can help you make more money and look good to lenders. If you have an asset that you think isn’t part of your main business activities, talk with your tax advisor to make sure you’re correctly recording its depreciation as a non-operating expense.
National Funding does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only. You should consult your own tax, legal and accounting advisors.
