Accounting

The Effect of Depreciation Expenditures on Cash Flow

As explained above, provision for depreciation in a given period reflects the value of the wear on fixed assets resulting from their use during that period.

Depreciation expenditures are treated as expenditure in the profit and loss statement, although no cash actually leaves the company in the case of depreciation.

In other words, in the profit and loss statement, depreciation expenditures are an element of cost of sales, and decrease the company’s profit, although no cash is actually paid for them. Cash actually left the company when the asset was purchased.

Example:

Company A conducts all its transactions in cash, and has no depreciation expenditures. It earned a $10 profit in 2008, and therefore added $10 to its cash.

Company B also conducts all of its transactions in cash, but it has $1 in annual depreciation expenditures. The company also earned a $10 profit in 2008, excluding deprecation. Following provision for depreciation, however, its net profit fell to $9.

Company A
No provision for depreciation

Company B

$1 provision for depreciation

Added Cash

Net Profit

Added Cash

Net Profit

$10

$10

$10

$9


Key

● = $ 1

○ = $ 0

 

 

This dollar was a provision for depreciation

To summarize, every dollar that the company lists as a provision for depreciation in the profit and loss statement decreases the net profit by $1, without a corresponding decrease in cash. This will be demonstrated through a simple example, in which the activity of USA Toys Company in 2008 is analyzed.

Example:

The Balance Sheet of USA Toys at the Beginning of 2007 is as Follows:

USA Toys’ Balance Sheet as of December 31, 2006 ($)

Assets

Liabilities + Equity

Current Assets

Liabilities

Cash

50,000

Bank loans

60,000

Fixed Assets

Machine

90,000

Equity

80,000

Total

140,000

Total

140,000

 

Activity in 2007:

Sales:

$80,000. Payment terms: Cash          

Expenditures:

Raw materials – $30,000. Payment terms: Cash

Salaries – $10,000. Payment terms: Cash

Miscellaneous expenditures – $10,000. Payment terms: Cash

Depreciation:

$10,000 (10% of the $100,000 purchase price of the machine)

The company’s profit and loss statement for 2007 is as follows:

USA Toys' profit and Los Statment for 2007($)

Sales 80,000
Raw materials 30,000
Salaries 10,000
Miscellaneous expenditures 10,000
Depreciation expenditures 10,000
Total cost of sales 60,000
Net profit 20,000

 

The Company’s Balance Sheet as of the End of 2007 is as Follows:

USA Toys’ Balance Sheet as of December 31, 2007 ($)

Assets

Liabilities + Equity

Current Assets

Liabilities

Cash

 (1) 80,000

Bank loans

60,000

Fixed Assets

Equity

80,000

Machine

(2) 80,000

Retained earnings

20,000

Total

160,000

Total

160,000


(1)

50,000

+

(80,000

-

50,000)

=

80,000

Cash – opening balance

Cash entering

Cash exiting


(2)

90,000

-

10,000

=

80,000

 

Machine- opening balance

Annual depreciation

The company’s cash flow includes $80,000 in entering cash (sales) and $50,000 in exiting cash (cost of sales, net of depreciation). The company’s cash from current activities therefore grew by $30,000. This cash flow can be shown as follows:

USA Toys' Cash Flow Statment for 2007 ($)

Cash Flow from current activity: 30,000
    Net profit 20,000
    Plus depreciation expenditures 10,000
Cash flow investment activity 0 - There was no activity in these spheres0
Cash flow from financing activity
Total increase in cash flow in 2007 30,000
Balance of cash at the begining of the period (January 1,2007) 50,000
Balance of cash at the end of the period (December 21,2007) 80,000

The Effect of Depreciation Expenditures on Cash Flow589  The Effect of Depreciation Expenditures on Cash Flow