Is depreciation a source of cash?

To what extent is depreciation (and other non-cash charges) a source of cash? Holding all
else constant, the answer depends on the level of income used for income taxes and dividend
payments.

"Depreciation is a source of funds" is a common but misleading statement. Taking this idea
literally creates the impression that by setting pencil to paper and increasing the depreciation
expenses, cash or funds will be generated.

It should be understood that depreciation does not provide cash --- only sales and external
financing can do this. Being a non-cash expense, depreciation is only a means of conserving
the outflow of cash from the firm. This is done by reducing the payments for income taxes and
dividends.The American Institute of CPAs clarified the relationship between depreciation and
cash in its discussion of the cash flow concept in financial literature.

"The expression cash flow, or any other similar term, in the literature of investments and
security analysis is usually the equivalent of 'funds provided by operations' in the typical funds
statement....

This concept has a valid factual background. Funds are normally acquired through the
earning of revenue. (In some cases a revenue item does not provide funds, as in the case of
the amortization of deferred income, and adjustments should be made for such items.) Unlike
the out-of-pocket-expenses, such as labor and materials, depreciation and other similar
expenses do not represent outlays of funds. Normally, therefore, there will be a balance of
available funds that is greater than the amount of net income. The net income of a business
does not indicate the full amount of spending power that is generated in a particular period by
revenue-earning operations, after providing for all of the current or short-term operating
requirements."
The addition of depreciation (or other such items) to the amount of net income is merely a
short cut technique for arriving at at the amount of funds derived from operations. This
adjustment helps to explain some of the things that have happened, such as how a business
has been able to modernize its plant or pay off a loan without borrowing more money or
issuing more shares of stock.

The term cash flow, however, is a misnomer --- it is neither cash nor flow. The net income is,
with rare exceptions, computed on an accrual basis, not on a cash basis. Adding back such
items as depreciation does not convert the net income to something that can properly be
called cash flow or income, since the result still reflects such things as the sales and purchase
of goods and services on account, the lag between the acquisition or production of
merchandise or products and their appearance on the income statement as a "cost of goods
sold" deduction, various accruals of income and expenses, and the amortization of deferred
charges or prepaid expenses and deferred credits (that should be and sometimes are
involved in the adjustment of net income).

If the purpose is to determine the degree to which depreciation conserves cash then the
question arises: Is depreciation 100 percent conserver of cash; if not, to what extent does it
conserve cash?

Required:
(a) Is depreciation a source of cash?
(b) If depreciation is not a source of cash, what might explain the belief by some that
depreciation is a source of cash?
(c) If depreciation is a source of cash, explain the manner in which depreciation
provides cash to the business.

Answer:
(a) Depreciation is neither a source nor a use of cash. Instead, depreciation is an
allocation of the cost of an asset over its useful life.
(b) A major cause of the belief that depreciation is a source of cash is the "add
back" presentation in the SCF prepared using the indirect format. This
presentation adds depreciation to net income and gives the erroneous
impression that it increases cash from operations.
(c) There is one sense in which depreciation is a source of cash, and for this
reason we must not overemphasize the idea that depreciation is not a source of
cash. Namely, when selling prices are sufficient to recover the depreciation
expense allocated to products sold, then revenues do provide management with
a discretionary, even if temporary, inflow of cash (assuming no significant
change in operating working capital). Normally, management will have to invest
this cash in fixed assets replacements to continue in business on a long-term
basis. However, in the event of a financial crisis or cash shortfall, management
has the option of diverting such cash to uses that will avert a liquidity crisis. This
is the one exception that may allow one to regard depreciation as a temporary
“source of cash.”

Depreciation does not directly impact the amount of cash flow generated by a business, but it
is tax-deductible, and so will reduce the cash outflows related to income taxes. Depreciation
is considered a non-cash expense, since it is simply an ongoing charge to the carrying
amount of a fixed asset, designed to 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 effect 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 effect on cash flow of depreciation is nullified by the underlying payment for a fixed
asset.