Depreciation expense on cash flow statement

Introduction

In accounting, the depreciation expense that we charge to the income statement represents the cost allocation of the fixed asset that we have purchased. Likewise, there is no cash involved when we make the depreciation on the fixed asset. Hence, depreciation expense on cash flow statement will be presented as an adjustment by adding it back to the net income in order to arrive at the net cash flow from operating activities.

In the preparation of the cash flow statement, the noncash expense will need to be added back to the net income as an adjustment under the operating activities section of the cash flow statement. This adjustment and other adjustments, such as changes in current assets and current liabilities, are required in order to convert the net income from the income statement to the net cash presented under the operating activities on the cash flow statement.

Depreciation expense on cash flow statement

Depreciation expense is similar to other expenses such as utilities, office supplies, rent expenses, etc. and they appear on the income statement as the reduction to the net income.

However, as mentioned, the depreciation expense is a type of expense that does not involve a current cash outflow like other expenses. Likewise, when we prepare the cash flow statement, we need to add back the depreciation expense to the net income in order to arrive at the net cash flow provided by operating activities.

Hence, we can present the depreciation expense on the cash flow statement as in the form below:

Cash flows from operating activities
	Net income		XXXX
	Adjustments
		Depreciation expense	XXXX
		Increase in non-cash current assets	(XXXX)
		Increase in current liabilties	XXXX
Net cash flows from operating activities			XXXX

Depreciation expense on cash flow statement example

For example, we have a $5,000 depreciation expense charged to the income statement during the accounting period and a net income of $100,000 on the income statement for the period.

And at the end of the accounting period, we have a reconciliation of the changes in the current assets and current liabilities as below:

Changes in current assets and current liabilities	Amount
Inventory increase	$6,000
Accounts receivable decrease	$2,000
Prepaid expenses decrease	$5,000
Accounts payable decrease	$1,000
Income taxes payable increase	$3,000

What is the net cash flow from operating activities?

Solution:

Since the $5,000 of the depreciation expense charged to the income statement during the period is a noncash expense, we can prepare the cash flow statement starting from operating activities as below:

Cash flows from operating activities
	Net income		$100,000
	Adjustments
		Depreciation expense	5,000
		Increase in inventory	(6,000)
		Decrease in accounts receivable	2,000
		Decrease in prepaid expenses	5,000
		Decrease in accounts payable	(1,000)
		Increase in income taxes payable	3,000
Net cash flows from operating activities			$108,000

Therefore, after the adjustments to reconcile net income to net cash flows from operating activities that include the $5,000 depreciation expense and other changes in current assets and current liabilities, we have a result of $108,000 net cash flows from operating activities on the cash flow statement.

Impact of depreciation expense on cash flow statement

As we have seen above, there is no direct impact of the depreciation expense on the cash flow statement. This is due to no matter how big the depreciation expense is, it will be added back to the cash flow when we make the reconciliation to convert net income to net cash flow under the operating activities section of the cash flow statement.

However, it does have an indirect impact on the cash flow statement where the depreciation expense will reduce taxable net income. In this case, the depreciation will reduce the amount of income tax that we must pay to the government for the period.

Hence, the indirect impact of the depreciation expense on the cash flow statement is that the bigger the depreciation expense allowed by the government, the bigger amount of depreciation can be claimed as the taxable expense and the lower amount of income tax we need to pay for the period resulting in lower cash outflow from the business for the period.

For example, the double-declining balance depreciation method is a type of depreciation method that charges a higher amount of depreciation expense in the early year which results in lower taxable net income in the early year. This will result in the business paying less income tax in the early year.

This method may be allowed by the government to encourage the new companies that have just started their business operations.