A:

Depreciation is a noncash accounting charge and does not have a direct impact on the amount of cash flow generated by a business or project. However, as long as there is sufficient taxable income to absorb it, depreciation is a tax-deductible expense and reduces tax cost, which has a positive impact on cash flow.

Depreciation in Financial Reporting

In accounting, the depreciation expense is used to allocate costs of long-lived assets in a rational, systematic pattern over the period the assets are expected to provide economic benefits. Therefore, in calculating operating results under U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS), depreciation is a deduction in arriving at income before income taxes. Because it is a noncash deduction, in a cash flow statement prepared under financial accounting standards, depreciation is presented as an adjustment in reconciling net income to operating cash flow.

Depreciation in Cash Flow Forecasts

While depreciation does not directly affect cash flow, the tax shield it provides can be an important part of cash flow forecasts used in financial analysis and capital budgeting. Depreciation is often calculated under different methods for financial accounting standards than for tax purposes.

The amount of the tax shield in any year is calculated by multiplying the tax-basis depreciation expense by the marginal tax rate applicable for that year. This tax shield is added to the after-tax operating cash flow forecast.

Suppose a forecast for a year shows sales of $2.5 million, cash operating expenses of $1.5 million, depreciation of $0.5 million, working capital and capital expenditures of $0.6 million, and a 40% tax rate. After-tax operating cash flows are (($2.5 million - $1.5 million) x (1 - 40%)) - $0.6 million, or zero. The tax shield is $0.5 million multiplied by 40%, or $0.2 million. Combining after-tax operating cash flow and the tax shield equals forecast cash flow of $0.2 million.

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