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Is depreciation a source of funds?

Author:
Harold Averkamp, CPA, MBA

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.

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About the Author

Harold Averkamp

For the past 52 years, Harold Averkamp (CPA, MBA) has
worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com.

Learn More About Harold

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