What is a Noncash Adjustment?
In accounting, a noncash adjustment is a concept used when creating a Statement of Cash Flows under the indirect method of cash flow preparation. The statement begins with the net profit or loss of the business and then adjusts the profit or loss figure for the effect of any transactions during the financial reporting period that did not involve the exchange of cash or equivalents.
Under both international financial reporting standards (IFRS) and United States generally accepted accounting principles (GAAP), the indirect method of cash flows may be used to show the change in the balance of cash and cash equivalents held by a financial reporting entity during a given period, typically a year. The indirect method of cash flows is used by financial statements to evaluate the sources and uses of cash by operating, financing, and investing activities. The ending value of the Statement of Cash Flows ties into the amount of cash and cash equivalents reported by the entity on its Statement of Financial Position, also commonly referred to as a Balance Sheet.
The starting point of a Statement of Cash Flows under the indirect method of cash flow preparation is the net profit or loss of the business as shown on the Statement of Comprehensive Income. This amount reflects the earnings (or loss) of the business from all sources during the financial reporting period. Under IFRS and GAAP, the net profit or loss is reflected on an accrual basis, meaning that it shows the effect of all accounting adjustments that present revenue when earned and expenses when incurred. These measures generally differ from presenting on a cash basis, which is recording revenue when received and expenses when paid.
In order to adjust to the cash flows from accrual basis to a basis that reflects the change in the cash position of the company, the cash flow statement compensates for the effect of all transactions that did not involve the use of cash during the period. This is what is known as a noncash adjustment. The most common noncash adjustment involves depreciation. Depreciation expense is a write-down in the value of assets held by the business. However, while depreciation expense reduce the net profits of a business, it does not involve a cash outlay. As a result, a noncash adjustment must be made to add back to net profit or loss the effect of the depreciation expense.
Other common noncash adjustments include an add-back for amortization expense. This is similar to depreciation expense, but reduces the accounting value of intangible assets. Income tax expense on an IFRS or GAAP basis differs from income tax actually paid. A noncash adjustment must be made for this difference. A third common difference involves foreign currency translation gains or losses. Foreign assets or liabilities must be often adjusted to the current value under IFRS or GAAP. This creates a gain or loss for which no cash is exchanged. As a result, a noncash adjustment must be made to compensate.