How is depreciation recorded on the statement of cash flows when using the indirect method?

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:

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

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.

The discussion on the indirect method of preparing the statement of cash flows refers to the line items in the following statement and the information previously given about the Brothers' Quintet, Inc. 

Operating activities

Although the total cash provided by operating activities amount is the same whether the direct or indirect method of preparing the statement of cash flows is used, the information is provided in a different format.

The indirect method assumes everything recorded as a revenue was a cash receipt and everything recorded as an expense was a cash payment. Remember that under the accrual basis of accounting, revenues and expenses are recorded following the revenue recognition and matching principles which do not require cash receipts to record revenues or cash payments to record expenses. The operating activities section starts with net income per the income statement and adjusts it to remove the significant non‐cash items.

Significant non‐cash items on the income statement include depreciation and amortization expense and gains and losses from the sales of assets or retirement of debt. As depreciation expense and amortization expense are deducted in calculating net income (expenses are subtracted from revenues to determine net income), and depreciation and amortization expense do not result in cash payments by the company, depreciation expense and amortization expense are added back to net income.

Given the financial statements and information for the Brothers' Quintet, Inc., net income is $6,300. Net income first needs to be adjusted by significant non‐cash items from the income statement: depreciation expense and the loss on the sale of the equipment.

Next, net income is adjusted for the changes in most current asset, current liability, and income tax accounts on the balance sheet. The accounts receivable balance decreased $663 from $19,230 to $18,567. As cash is increased when cash is collected from customers, a decrease in the accounts receivable balance represents an increase in cash. Therefore, the $663 is added back to net income. If the accounts receivable balance increases, the amount of the increase is subtracted from net income, the opposite of what happens when the balance decreases. The inventory balance increased $107. As inventory is purchased, cash is assumed to be paid, so the $107 increase in the inventory balance is subtracted from net income (a decrease in the inventory balance would be added to net income). Similarly, the $142 increase in the prepaid expenses balance is also deducted from net income. The accounts payable balance decreased $919. When cash is paid to a supplier for purchases previously made on account, cash decreases. Thus, a decrease in the accounts payable balance represents a decrease in cash and the $919 decrease is subtracted from net income.

An increase in the accounts payable, or any current liability account balance is added to net income. The wages payable balance increased because a larger accrual was made to represent wages owed at the end of 20X1 than 20X0. Accrued wages are owed but not paid at the end of the month. An increase in a current liability account balance means cash has not been paid and therefore, the $320 increase in the wages payable balance is added to net income. The decrease in the accrued expenses balance of $1,295 is subtracted from net income. Once all of the changes in the current asset, current liability, and income tax accounts have been listed, the total cash provided by (used by) operating activities is determined by totaling all of the activity. Notice the amounts of any decreases are in parentheses.

Investing activities and financing activities

The investing and financing sections of the statement of cash flows are prepared in the same way for the indirect method as for the direct method.