Some people state that depreciation is a source of funds or a source of cash. I disagree.

Depreciation expense is reported as a positive amount on the statement of cash flows prepared under the popular indirect method. However, the reason it is listed is to adjust the net income amount that had been reduced by depreciation expense on the income statement. (Recall that the depreciation entry debits Depreciation Expense and credits Accumulated Depreciation—the cash account is not involved.) In other words, the positive depreciation amount reported on the statement of cash flows is merely one of the adjustments needed to convert the accrual net income to the cash provided from operating activities. Depreciation is not a source of cash.

Let's illustrate this with some amounts. A sidewalk florist operates a cash only business. During the most recent year, this florist had cash revenues of $100,000. Its expenses included $70,000 of cash expenses and $8,000 of depreciation expense on its truck that was purchased in an earlier year. During the year there were no other revenues or expenses, and the florist's cash balance increased by $30,000. The florist's income statement will report net income of $22,000 (revenues of $100,000 minus expenses of $78,000).

The florist's statement of cash flows prepared under the indirect method will begin with net income of $22,000. It will then add the $8,000 of depreciation expense. The result is cash provided by operating activities of $30,000—which agrees to the business's change in its cash balance.

The $8,000 of depreciation expense was not a source of cash, even though it appears as a positive amount on the statement of cash flows.

Editor's note: A reader's comment points out that the depreciation on the income tax return will reduce taxable income and that in turn will likely reduce the amount of cash paid for income taxes. This reduction in income taxes is a source of cash.

To learn more, see the Related Topics listed below: