Depreciation doesn’t impact cash flow because it is a noncash expense. However, depreciation has an effect on the cash flow statement when the indirect method is used in computing cash flows from operating activities. Understanding the impact of depreciation on cash flow in the operating activities section can help you plan out future cash flows by using accrual net income figures.
Effect of Depreciation on the Cash Flow Statement
The indirect method of preparing the operating activities of the cash flow statement starts with accrual-basis net income. By removing the noncash revenues and expenses, you’ll arrive at cash flow from operations.
Depreciation expense is one of the noncash deductions from accrual net income. Since depreciation was deducted, it is a positive adjustment (i.e., it is added back) to accrual net income when the indirect method is used in computing cash flow from operations.
Under the indirect method, we use the accrual-basis net income as the base figure for determining cash flow from operations. From the accrual-basis net income amount, we have to convert accrual net income to cash flow from operations by doing the following:
- Adding back depreciation and amortization expense because they were deducted from accrual-basis net income but do not reduce cash flow
- Removing effects of accrual accounting from accrual-basis net income (e.g., accrued expenses and revenues)
Example
Let’s assume a company has the following cash flow and net income for the year:
| Cash Flow | Accrual Net Income | Difference | |
|---|---|---|---|
| Sales | $143,000 | $168,000 | $25,000 |
| Expenses | ($50,000) | ($60,000) | ($10,000) |
| Depreciation | -0- | ($8,000) | ($8,000) |
| Cash Flow/Net Income | $93,000 | $100,000 | $7,000 |
Based on this information, the company will need the following adjustments on its indirect method cash flow statement to reconcile net income to operating cash flow:
- Increase in A/R of $25,000: Since accrual-basis sales was $25,000 higher than the cash collected, A/R must have increased by $25,000.
- Increase in Accrued Expenses of $10,000: Since accrual-basis expenses were $10,000 higher than cash expenses, accrued expenses must have increased by $10,000
- Depreciation expense of $8,000: Since depreciation is deducted from net income but is not a cash outflow, it must be added back to net income.
Operating cash flow computation:
| Accrual Net Income | $100,000 |
|---|---|
| + Depreciation Expense | $8,000 |
| − Increase in A/R | $25,000 |
| + Increase in A/P | $10,000 |
| Cash Flow From Operating Activities | $93,000 |
In the example above, we added depreciation back to net income to cancel out its initial deduction from accrual net income and to determine the cash flow from operating activities.
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Depreciation Lowers Cash Paid for Taxes
While depreciation is not the result of cash payments during the period, it does result in a secondary effect on cash flow. Depreciation reduces taxable income, which reduces the tax due—and less tax due means less cash payments for taxes.
So, depreciation impacts cash flow indirectly through the tax savings it generates. It has an indirect effect because there are other factors that might offset the tax savings of depreciation deductions. However, you can still compute the increase in cash flow.
Let’s assume the data below:
- Depreciation expense: $20,000
- Tax rate: 21%
Our tax savings by deducting depreciation is
Tax savings = $20,000 × 21% = $4,200
The tax savings here means that we have reduced cash outflows of $4,200 since tax due is lesser by $4,200. However, other items may offset this tax savings, so don’t immediately conclude that your tax due will be $4,200 less.
Frequently Asked Questions (FAQs)
How can depreciation affect cash flow?
Depreciation—which isn’t a cash expense—indirectly affects cash flow by reducing the amount of tax you pay. Since depreciation deductions reduce taxable income, it means that it reduces the final tax due.
Is depreciation a noncash expense?
Yes, depreciation is a noncash expense. It means that depreciation expense isn’t the result of a current period cash payment.
Why is depreciation added in computing operating cash flow?
We add depreciation back because it is deducted from net income in accrual accounting, which is the starting point in a cash flow statement. Adding back depreciation is one of the necessary steps to convert accrual-basis net income into cash flow.
Bottom Line
Understanding the effects of depreciation on cash flow can help businesses make informed decisions based on actionable information from financial statements. Due to depreciation being a consequence of accrual accounting, readers of financial statements without accounting knowledge may find it difficult to understand its concept. However, we hope this article was able to explain how to treat depreciation when dealing with cash flow.
