Ways to Handle Depreciation on Cash Flow Statement
The information that analysis of your cash flow statement provides is key to effectively managing your cash to remain both profitable and cash-rich. Depreciation is an accounting tool that impacts all of your company's financial statements -- the income statement, cash flow statement and balance sheet. Depreciation is a non-cash item and therefore increases the cash shown on your cash flow statement.
Depreciation is an accounting principle that acknowledges the useful life of an asset and accounts for wear and tear on a long-term asset, which is an asset with a lifespan of more than one year. Depreciation enables your company to transfer a portion of your asset's cost from the balance sheet to the income statement over a period of time. Depreciable assets include property, except for land, buildings, equipment, vehicles and furniture. Depreciation's sister, amortization, is the term more often used to describe deterioration or obsolescence of intangible assets including software, patents and copyrights.
Your company's cash flow statement links your income statement to your balance sheet. Analysis of your cash flow statement reveals how the assets and liabilities that appear on your balance sheet impact your cash and cash flow. It also shows how your business' revenue and profit-producing activities impact cash. The cash flow statement contains three separate sections -- operating activities, investing activities and financing activities. Depreciation appears in the operating section.
Most small businesses depreciate assets on a yearly basis. You can use different depreciation methods including straight line or accelerated cost recovery, but the method you choose must be a method allowed by the IRS for that asset type. After you purchase an asset, the asset appears on your balance sheet. The investing section of your cash flow statement will show a reduction in cash to pay for the asset.
As you depreciate the asset, your balance sheet will show a contra account, depreciation, below the asset. That year's depreciation amount will appear as a depreciation expense on your income statement. On the cash flow statement in the operating section, you will record a depreciation addback. This means that you will increase your cash flow by the amount of your depreciation expense since you did not actually spend cash on that expense.
At the end of the year you purchase machining equipment for $50,000 and opt to pay cash instead of using financing. You record a decrease of $50,000 in the investing activities section of your cash flow statement. The cash on your balance sheet decreases by $50,000 and you add an asset, "machining equipment" to your balance sheet with a value of $50,000.
At the end of the following year, you record $5,000 in depreciation expense for your machining equipment on your income statement. On your cash flow statement you add back this $5,000 and record it as an increase to cash in the operating activities section. Your balance sheet now reads machining equipment $50,000, depreciation ($5,000), for a net asset value of $45,000.