Depreciation moves the cost of an asset to Depreciation Expense during the asset's useful life. The accounts involved in recording depreciation are Depreciation Expense and Accumulated Depreciation. As you can see, cash is not involved. In other words, depreciation reduces net income on the income statement, but it does not reduce the Cash account on the balance sheet.

Because we begin preparing the statement of cash flows using the net income figure taken from the income statement, we need to adjust the net income figure so that it is not reduced by Depreciation Expense. To do this, we add back the amount of the Depreciation Expense.

Depletion Expense and Amortization Expense are accounts similar to Depreciation Expense, as all three involve allocating the cost of a long-term asset to an expense over the useful life of the asset. There is no cash involved.

In the operating activities section of the cash flow statement, add back expenses that did not require the use of cash. Examples are depreciation, depletion, and amortization expense.

Let's illustrate how a depreciation expense is handled by continuing with the Good Deal Co.

The only transaction recorded by Good Deal during June was the depreciation on the office equipment. Recall that on May 31 Good Deal purchased the office equipment (a new computer and printer) for $1,100 and it was put into service on the same day. Let's assume that a depreciation expense of $20 per month is recorded by Good Deal. As a result, Good Deal's financial statements at June 30 will be as follows:

Good Deal Co. Income Statement For the Month Ended June 30, 2010 Revenues $  0  Expenses Depreciation Expense   20  Net Income $(20)

Good Deal Co. Income Statement For the Six Months Ended June 30, 2010 Revenues $800 Expenses Cost of Goods Sold 500 Depreciation Expense     20 Total Expense   520 Net Income $280

Good Deal Co. Balance Sheet June 30, 2010 Assets Liabilities & Owner's Equity Cash $   850  Liabilities Accounts Receivable 0  Accounts Payable $       0 Inventory 200  Owner's Equity Supplies 150  Matt Jones, Capital (excl. net inc.) 2,000 Office Equipment 1,100  Matt Jones, Curr Yr. Net Income      280 Less: Accum. Depreciation      (20) Total Matt Jones, Capital   2,280 Total Assets $2,280  Total Liabilities & Owner's Equity $2,280

A balance sheet comparing June 30 to May 31 and the resulting differences or changes is shown below:

Good Deal Co. Balance Sheets June 30 and May 31, 2010 Assets 6-30-10  5-31-10 Change  Cash $   850  $   850 $   0  Accounts Receivable 0  0 0  Inventory 200  200 0  Supplies 150  150 0  Office Equipment   1,100  1,100 0  Less: Accumulated Depreciation      (20)          0   (20) Total Assets $2,280  $2,300 $(20) Liabilities & Owner's Equity Liabilities Accounts Payable $       0  $       0 $   0  Owner's Equity Matt Jones, Capital (excl. net inc.) 2,000  2,000 0  Matt Jones, Curr Yr. Net Income      280       300   (20) Total Matt Jones, Capital   2,280    2,300   (20) Total Liabilities & Owner's Equity $2,280  $2,300 $(20) (If you are wondering why June 30 is shown before May 31, it is because accountants usually place the most current amounts closest to the account names. This is a courtesy to the reader in that these are assumed to be the more important amounts and will be easier to read if placed closest to the words.)

Good Deal Co. Statement of Cash Flows For the Month Ended June 30, 2010 Operating Activities Net Income $ (20) Add: Depreciation Expense     20  Cash Provided (Used) in Operating Activities 0  Investing Activities 0  Financing Activities       0  Net Increase in Cash     0  Cash at the beginning of the month   850  Cash at the end of the month $850

The cash flow statement for the month of June illustrates why depreciation expense needs to be added back to net income. Good Deal did not spend any cash in June, however, the entry in the Depreciation Expense account resulted in a net loss on the income statement. To convert the bottom line of the income statement (a loss of $20) to the amount of cash provided or used in operating activities ($0) we need to add back or remove the depreciation expense amount.

Good Deal Co. Balance Sheets June 30, 2010 and December 31, 2009 Assets 6-30-10  12-31-09 Change  Cash $   850  $   0 $    850  Accounts Receivable 0  0 0  Inventory 200  0 200  Supplies 150  0 150  Office Equipment   1,100  0 1,100  Less: Accumulated Depreciation      (20)      0      (20) Total Assets $2,280  $   0 $2,280  Liabilities & Owner's Equity Liabilities Accounts Payable $       0  $   0 $       0  Owner's Equity Matt Jones, Capital (excl. net inc.) 2,000  0 2,000  Matt Jones, Curr Yr. Net Income      280       0      280  Total Matt Jones, Capital   2,280       0   2,280  Total Liabilities & Owner's Equity $2,280  $   0 $2,280

Good Deal Co. Statement of Cash Flows For the Six Months Ended June 30, 2010 Operating Activities Net Income $   280  Add back: Depreciation Expense 20  Increase in Inventory (200) Increase in Supplies     (150) Cash Provided (Used) in Operating Activities (50) Investing Activities Increase in Office Equipment (1,100) Financing Activities Investment by Owner   2,000  Net Increase in Cash    850  Cash at the beginning of the year         0  Cash at June 30, 2010 $   850

Let's review the cash flow statement for the six months ended June 30:

• The operating activities section starts with the net income of $280 for the six-month period. Depreciation expense is added back to net income because it was a noncash transaction (net income was reduced, but there was no cash spent on depreciation). The increase in the Inventory account is not good for cash, as shown by the negative $200. Similarly, the increase in Supplies is not good for cash and it is reported as a negative $150. Combining the amounts, the net change in cash that is explained by operating activities is a negative $50.
• The increase in long-term assets caused a cash outflow of $1,100 which is reported in the investing activities section.
• There were no changes in long-term liabilities. There was a change in owner's equity since December 31, and as a result the financing activities section reports the owner's $2,000 investment into the Good Deal Co.
• Combining the operating, investing, and financing activities, the statement of cash flows reports an increase in cash of $850. This agrees with the change in the Cash account as shown on the balance sheets from December 31, 2009 and June 30, 2010.

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