Is Depreciation Added Back as Operating Income?
Depreciation is the allocation of a fixed asset's acquisition costs over its useful life, which is usually substantially more than a year. Operating income is the gross margin minus operating expenses, which includes depreciation expenses. Gross margin is sales minus cost of goods sold. Depreciation expenses are added back to net income for cash flow reporting purposes. Net income is operating income minus interest and taxes.
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Facts
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The journal entries for depreciation are to debit (increase) the depreciation expense account and credit (increase) the accumulated depreciation account. Accumulated depreciation is a contra account that reduces the book value of a company's fixed assets. The net book value of an asset is its acquisition cost minus the accumulated depreciation. The most common depreciation method is straight-line depreciation, in which the same amount is depreciated over an asset's useful life. For example, the annual depreciation expense for a $5,000 computer with a useful life of five years is $1,000 ($5,000 / 5).
Operating Income
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Operating income is a company's profit after the cost of goods and operating expenses are deducted from sales. For example, if sales are $1 million, cost of goods sold is $400,000 and operating expenses are $300,000, then the gross margin is $600,000 ($1 million - $400,000) and the operating income is $300,000 ($600,000 - $300,000). Depreciation expenses are part of operating expenses. Therefore, a high depreciation expense lowers the operating income. Operating income is also known as earnings before interest and taxes, or EBIT.
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Cash Flow Statement
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Depreciation is a non-cash expense, which means there is an accounting entry but no corresponding cash expenditure. A cash flow statement usually has three sections: cash flow from operating activities; cash flow from investing activities, such as new facility construction and acquisitions; and cash flow from financing activities, such as issuing new bonds or stock. The cash flow from operating activities section starts with the net income, followed by adjustments for depreciation and other items. For example, if the net income is $100,000 and the depreciation expenses are $10,000, the cash flow from operating activities before other adjustments is $110,000 ($100,000 + $10,000).
Considerations: EBITDA
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EBITDA (earnings before interest, taxes, depreciation and amortization) is the operating income with depreciation and amortization expenses added back. Amortization is the gradual allocation of certain balance sheet items, such as discounts on bonds or intangible assets. According to the AccountingTools website, EBITDA provides a rough cash flow estimate, including funds available for debt repayments, and allows comparative evaluation of companies in the same industry.
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