BUS103: Introduction to Financial Accounting

Noncash items, such as depreciation and amortization, will affect differences between the income statement and cash flow statement.

Learning Objective

• Identify noncash items that can affect the income statement

Key Points

• Noncash items should be added back in when analyzing income statements to determine cash flow because they do not contribute to the inflow or outflow of cash like other gains and expenses eventually do.
• Depreciation refers to the decrease in value of assets and the allocation of the cost of assets to periods in which the assets are used--for tangible assets, such as machinery.
• Amortization is a similar process to deprecation when applied to intangible assets, such as patents and trademarks.
  

Terms

• depreciation
  The measurement of the decline in value of assets. Not to be confused with impairment, which is the measurement of the unplanned, extraordinary decline in value of assets.
  
  
• amortization
  The distribution of the cost of an intangible asset, such as an intellectual property right, over the projected useful life of the asset.
  
  
• obsolescence
  The state of being obsolete - no longer in use; gone into disuse; disused or neglected.
  

Noncash Items

Noncash items that are reported on an income statement will cause differences between the income statement and cash flow statement. Common noncash items are related to the investing and financing of assets and liabilities, and depreciation and amortization. When analyzing income statements to determine the true cash flow of a business, these items should be added back in because they do not contribute to inflow or outflow of cash like other gains and expenses.

Fixed assets, also known as a non-current asset or as property, plant, and equipment (PP&E), is an accounting term for assets and property. Unlike current assets such as cash accounts receivable, PP&E are not very liquid. PP&E are often considered fixed assets: they are expected to have relatively long life, and are not easily changed into another asset . These often receive a more favorable tax treatment than short-term assets in the form of depreciation allowances.

Machinery
Machinery is an example of a noncash asset.

Broadly speaking, depreciation is a way of accounting for the decreasing value of long-term assets over time. A machine bought in 2012, for example, will not be worth the same amount in 2022 because of things like wear-and-tear and obsolescence.

On a more detailed level, depreciation refers to two very different but related concepts: the decrease in the value of tangible assets (fair value depreciation) and the allocation of the cost of tangible assets to periods in which they are used (depreciation with the matching principle). The former affects values of businesses and entities. The latter affects net income.

In each period, long-term noncash assets accrue a depreciation expense that appears on the income statement. Depreciation expense does not require a current outlay of cash, but the cost of acquiring assets does. For example, an asset worth 100,000 in year 1 may have a depreciation expense of 10,000, so it appears as an asset worth $90,000 in year 2.

Amortization is a similar process to deprecation but is the term used when applied to intangible assets. Examples of intangible assets include copyrights, patents, and trademarks.