Depreciation is the way accountants account for the wear and tear on assets. Every year, as the asset generates revenues for the company, depreciation is written off the value of assets and expensed on the income statement as a reduction to operating income. The best way to analyze depreciation as an item on the cash budget is to understand its components and uses.
There are three main variables to depreciation expense, they are the salvage value, useful life and asset cost. Each one provides information about how to account for the wear and tear of assets over time. The salvage value is the value of the asset at the end of its useful life. The useful life is determined by estimating the number of years the asset will be able to add value to the company, and the cost of the asset is the price paid to obtain the asset.
Depreciation is expensed on the income statement and deducted from assets on the balance sheet. The balance sheet provides a tally of the company's asset values. Every year the depreciation expense is written off the income statement, it is also deducted from the total value of assets on the balance sheet. So on the balance sheet, the result is a reduction in asset value, and on the income statement the result is a lower net income.
The cash flow statement is created from both the balance sheet and the income statement. It provides an overview of the cash transactions in the business. While depreciation is an actual expense for accounting and tax purposes, it does not result in an outflow of cash. This is why depreciation is added back to income from operations on the cash flow statement.
Just because depreciation is not a cash expense and therefore does not need to be budgeted for directly in a cash budget, there is one major cash affect -- taxes. For instance, depreciation lowers reported net income, which can also reduce cash taxes paid to the IRS. The higher the depreciation expense, the lower the income taxes paid. Since depreciation is a non-cash expense, companies like to use depreciation as a tax haven.