Depreciation

As the lemonade stand case showed, depreciation expense simply allocates the costs of the original purchase of fixed assets over their useful lives (Exhibits 7.3 and 7.4) and is a noncash expense; that is, it does not depict any actual cash outflow (payment).

Exhibit 7.3. Depreciation Allocates Costs of Fixed Assets Over Their Estimated Useful Lives ...
The Lemonade Stand Revisited 

  • You purchased a lemon squeezer and a lemonade stand for $30 and estimated that both of these fixed assets will have a useful life of 3 years, by the end of which they will be obsolete and be thrown away.

  • It is important to recall that even though you paid cash up front for the entire cost of the machine, you did not expense the entire $30 cost on the income statement.

  • Instead, you estimated a useful life of the squeezer for generating lemonade (i.e., revenues for your business) to be 3 years, and so you spread the depreciation expense (at $10 per year) over this period in order to match revenues and expenses, as required by the accrual accounting.


Exhibit 7.4. . . . And is Therefore a “Noncash” Expense
Year 1

  • D&A expense was $10 (as shown on the right)

  • Actual cash expense was $30

Year 2

  • D&A expense is $10

  • Cash expense is $0 – you already paid for the machine in year 1

Year 3

  • D&A expense is $10

  • Cash expense is $0


In the lemonade stand example, you recorded depreciation expense of $10 and net income of $30 on your income statement for 2007. However, since depreciation expense does not depict any actual cash outflow (payment), the lemonade stand actually took in $40 in cash. Accordingly, depreciation expense of $10 must be added back to net income (Exhibit 7.5) on the cash flow statement in order to accurately depict the amount of cash generated by the company’s operations.

Exhibit 7.5. Depreciation is a Noncash Expense and Must Be Added Back to Net Income to Arrive at the Amount of Cash Generated by Operating Activities

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