Question

In determining the cash flow from operating activities using the indirect method, why is it necessary to add

depreciation back to net income? Give an example of another item that is added back to net income under

the indirect method

Answer 1

Because when we are preparing a cash flow statement under indirect method, we begin with the net income figure taken from the income statement. Since depreciation moves the cost to depreciation expense. We can clearly see here that no cash flow is involved. Here depreciation reduces the net income on the income statement, but it does not reduce cash account on the balance sheet. So we need to adjust the net income figure so that it is not reduced by depreciation expense. To do this we add back the amount of depreciation expense.

Depletion expense and Amortization expenses are the accounts similar to Depreciation expense, as all three involve allocating the cost of a long term asset to an expense over useful life of the asset, there is no cash involved.

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