Depreciation moves the cost of an asset from the balance sheet to Depreciation Expense on the income statement in a systematic manner during an asset's useful life. The accounts involved in recording depreciation are Depreciation Expense and Accumulated Depreciation. As you see, cash is not involved. In other words, depreciation reduces net income on the income statement, but it does not reduce the company's cash that is reported on the balance sheet.
Since we begin the statement of cash flows with the net income figure taken from the income statement, we need to adjust the amount of net income by adding back the amount of the Depreciation Expense.
Depletion Expense and Amortization Expense are accounts similar to Depreciation Expense. They involve allocating the cost of a long-term asset to an expense over the useful life of the asset, but no cash is involved.
Here's a Tip
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.
Next, we examine how depreciation expense is reported on the Good Deal Co.'s financial statement.
June Transactions and Financial Statements
The only transaction recorded by Good Deal during June was the depreciation of its 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 next day. Let's assume that 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:
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. On the SCF, we convert the bottom line of the income statement for the month of June (a loss of $20) to the net amount of cash provided or used by operating activities, which was $0. This is done with a positive adjustment which adds back the $20 of depreciation expense.
The following comparative balance sheet shows the changes between December 31, 2020 and June 30, 2021:
The SCF for the period of January 1 through June 30 is:
Let's review the cash flow statement for the six months ended June 30:
The operating activities section began 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 outflow for depreciation). The increase in the Inventory account was not good for cash, as shown by the negative $200. Similarly, the increase in Supplies was 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 investing activities section reports the cash outflow of $1,100 for the purchase of office equipment.
There were no changes in short-term loans payable or long-term liabilities. However, there was the owner's $2,000 investment in the Good Deal Co. Therefore, the financing activities section reports a positive 2,000.
Combining the amounts from the operating, investing, and financing activities, the SCF reports an increase in cash of $850. This agrees with the change in the Cash amounts reported on the balance sheets dated December 31, 2020 and June 30, 2021.