Operating Expenses
Operating expenses are diverse and may include advertising, selling and administrative expenses, depreciation, research and development, maintenance and repairs, and even lease payments.
Items such as research and development are only required to be listed as separate line items if they represent a significant and material value. Only about a third of listed companies disclose their research and development expenses; the vast majority of these firms operate in the technology and health care sectors.
Depreciation expense is the allocation to this year's revenue of a portion of the cost of long-lived assets such as buildings, machinery, trucks, and autos. Depreciation charges reflect the useful lives of the assets, their original cost, and estimated salvage value. Depreciation expense is a non-cash expense. The cash for the asset depreciating in value was spent when the asset was purchased. Depreciation attempts to capture the use and depletion of the asset over the course of the reporting periods. It reduces reported taxable income, although it does not actually represent the use of cash. By lowering the pretax income and thereby the firm's tax liability, it may actually help to decrease cash outflow from the company. Various depreciation methods are available to the firm such as straight-line and accelerated. The choice of depreciation methods will affect earnings over the depreciation schedule of the asset. For example, an accelerated depreciation schedule will reduce the value of an asset at a faster pace early in the asset's life, but more slowly at the end of the asset's life. Under an accelerated depreciation schedule, depreciation will be higher early in the asset's life accompanied with a higher operating expense, lower pretax income, lower tax liability, and lower reported earnings. The firm must also estimate the useful life of the asset. A longer life will result in a lower annual expense at the cost of stretching out the expenses over a longer period. While guidance is provided for common assets such as cars (five years) and buildings (31.5 years), companies still have some discretion. For example, two airlines may estimate different useful lives for the same type of airplane.
Subtracting operating expenses from gross income provides the next income step—operating income. Operating income or earnings before interest and taxes (EBIT) represents income generated for the period after all costs except interest, taxes, non-operating costs, and extraordinary charges. Operating income reflects the organizational and productive efficiency of the firm before considering how the firm was financed or the contribution (or drag) of non-business activities.
Non-Operating Expenses
Interest expense includes interest paid by the firm on all outstanding debt and may also include loan fees and other related financing costs. The special nature of interest leads to separate reporting. Interest is a financial cost, not an operating cost. Interest cost is dependant upon the financial policies of the firm without regard to nature or efficiency of the firm's operation.
If the company had additional non-operating expenses or profits, they would also be listed after the operating expenses, but before the tax liabilities. Common elements include interest income from investments and gain or loss from the sale of assets. These are items not related to the sales revenue activity of the firm and need to be tracked separately to measure their impact on bottom line income.
Subtracting non-operating expense from operating income leaves income or earnings before taxes (EBT). This is the third income step and a step that cumulates all revenue and expenses with the exception of a potential tax liability.
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