The indirect cash flow statement includes adjustments for non cash expenses which are transactions that do not involve the movement of cash.
Non cash expenses can relate to any of the categories shown on the cash flow statement which include operating, investing and financing activities.
Examples of Non Cash Expenses
There are various types of non cash expenses, the most commonly seen include the following:
Depreciation, Depletion and Amortization
Most long term assets have a limited useful life and reduce in value over time. An estimate of this reduction is treated as an expense in the income statement each accounting period and recorded under the heading of either depreciation, depletion, or amortization.
As an example, suppose a business purchased an asset costing 10,000 with a useful life of 5 years and zero salvage value. When the asset was purchased cash flowed out of the business for the original cost of 10,000 and this would be recorded in the cash flow statement as part of cash flow from investing activities.
The depreciation expense for the next 5 years is 2,000 (10,000 / 5). This expense will be included in the income statement with the following bookkeeping entry:
It can be seen that this entry is simply an accounting entry and does not involve the movement of cash. However, the starting point of the cash flow statement is the net income of the business, and this has been reduced by the depreciation expense of 2,000. To correct the position for the cash flow statement, the depreciation expense needs to be added back to the net income as it is a non cash expense.
Changes in Deferred Income Taxes
Deferred tax results from the different treatment of income, expenses, assets and liabilities by the business and the tax authorities.
Suppose a business has a deferred tax expense of 1,000 as a result of the different treatment of depreciation by the business and the tax authorities. The bookkeeping journal to record this is as follows:
|Income tax expense||1,000|
|Deferred tax liability||1,000|
As with depreciation, the entry is simply an accounting entry and does not involve the movement of cash. However, again, the net income of the business has been reduced by the increased income tax expense of 1,000. To correct the position for the cash flow statement, the income tax expense resulting from the deferred tax liability, needs to be added back to the net income as it is a non cash expense.
Amortization of Bond Discount and Premium
If bonds are issued below their par value, the resulting bond discount needs to be amortized over the term of the bond.
Suppose a business issues bonds at a discount of 5,000 and uses the straight line method to amortize this discount over a 4 year period. The accounting entry to post this amortization is as follows:
|Discount on bonds payable||1,250|
Each period a portion 1,250 (5,000/4) of the discount is treated as an interest expense in the income statement and reduces the net income of the business. As can be seen from above, the posting is an accounting entry, and does not involve the movement of cash and needs to be added back in the cash flow statement.
Summary Cash Flow Statement
In summary, each of the non cash expenses reduced the net income of the business and therefore needs to be added back to net income when this is used as the starting point for the cash flow statement.
Suppose in the above examples the net income of the business was 5,000, then the cash flow from operating activities is calculated (assuming no other adjustments) by adding back the non cash expenses as follows:
|Add back depreciation||2,000|
|Add back deferred tax||1,000|
|Add back bond discount||1,250|
|Cash flow from operating activities||9,250|
|. . .|
The net income of 5,000 has been reduced by the non cash expenses totaling 4,250. When producing the cash flow statement these are added back and the cash flow from operating activities is increased to 9,250. It should be noted that the non cash expenses are an accounting adjustment they are not a source of cash.
Of course this post deals with non cash expenses, the opposite effect occurs when there are non cash credits (such as a deferred tax asset or a bond issued at a premium) included in net income. In this case the non cash credits must be deducted from the net income in the cash flow statement.
As a typical example of the treatment of non cash charges, the Apple cash flow statement shows the adjustments for non cash expenses relating to depreciation and amortization, share-based compensation expense, and the deferred income tax expense.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.