Definition of Depreciation
Depreciation is the systematic allocation of the cost of a business asset to expense over the useful life of the asset. The accounting for depreciation is a debit to Depreciation Expense and a credit to Accumulated Depreciation. As you can see, the entry does not involve the account Cash. Hence, depreciation expense is referred to as a noncash expense.
Example of Depreciation
Assume that a sidewalk florist operates a cash only business. During the most recent year, the florist had cash revenues of $100,000, cash expenses of $70,000, and depreciation expense of $8,000. Therefore, the net income reported on its income statement was $22,000. (The depreciation pertains to a truck purchased in an earlier year.)
Depreciation and the Statement of Cash Flows
The florist’s statement of cash flows (using the indirect method) begins with the net income of $22,000. Next, the depreciation expense of $8,000 is shown as a positive amount and is added to the net income to arrive at $30,000, which equals the cash receipts of $100,000 minus cash expenses of $70,000.
Depreciation expense was added to the net income because the depreciation expense had reduced net income but cash was not reduced. In other words, the positive $8,000 of depreciation expense is not a source of cash, it is merely a needed adjustment to convert the accrual net income to the cash provided from the florist’s operating activities.
While the amount of depreciation expense is not a source of cash, it does reduce a corporation’s taxable income. That in turn reduces a profitable corporation’s cash payments for income taxes (by the amount of the corporation’s income tax rate). The savings of income tax payments is equivalent to a source of cash.
