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    Accounting Standards Library
    Wednesday
    Aug082012

    How does depreciation affect cash flow?

    Depreciation is considered a non-cash expense, since it is simply an ongoing charge to the carrying amount of a fixed asset, designed to gradually reduce the recorded cost of the asset over its useful life. When creating a budget for cash flows, depreciation is typically listed as a reduction from expenses, thereby implying that it has no impact on cash flows. Nonetheless, depreciation does have an indirect affect on cash flow.

    When a company prepares its income tax return, depreciation is listed as an expense, and so reduces the amount of taxable income reported to the government (the situation varies by country). If depreciation is an allowable expense for the purposes of calculating taxable income, then its presence reduces the amount of tax that a company must pay. Thus, depreciation affects cash flow by reducing the amount of cash a business must pay in income taxes.

    This tax effect can be increased if the government allows a business to use accelerated depreciation methods to increase the amount of depreciation claimed as a taxable expense, which thereby reduces the amount of cash outflow for tax payments even further in the short term (though this leaves less depreciation to claim in later periods, which reduces the favorable tax effect in those periods).

    However, depreciation only exists because it is associated with a fixed asset. When that fixed asset was originally purchased, there was a cash outflow to pay for the asset. Thus, the net positive affect on cash flow of depreciation is nullified by the underlying payment for a fixed asset.

    Related Topics

    Financial statement analysis 
    Profit velocity analysis 
    What is free cash flow? 
    What is the accounting rate of return? 

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