Question

In a worksheet for the statement of cash flows, a worksheet entry that includes a credit to accumulated depreciation will also include a: a. credit in the operating section and a debit in another section. b. debit in the operating section. c. debit in the investing section. d. debit in the financing section.

Short answer

b. debit in the operating section.

Step-by-step solution

Understanding the Role of Accumulated Depreciation

Accumulated depreciation is a contra-asset account used for accounting purposes to track the depreciation of tangible assets. It is credited when depreciation expense is recorded for the period, reducing the asset's book value on the balance sheet. In the cash flow statement, it impacts the operating activities section.

Determining the Impact on the Cash Flow Statement

In a statement of cash flows (indirect method), depreciation (including accumulated depreciation) is a non-cash expense and is added back to net income in the operating activities section to adjust for non-cash charges that decrease net income but don't affect cash flow.

Analyzing the Corresponding Debit Entry

The credit to accumulated depreciation implies that the depreciation expense must have been initially debited. In the worksheet for the statement of cash flows, to counter the increase in accumulated depreciation (non-cash expense), a debit to depreciation expense is made, which is included in the operating activities section to adjust net income.

Final Step: Choosing the Correct Answer

Considering the role of accumulated depreciation and how depreciation is treated in the cash flow statement, the correct choice based on the effect of an accumulated depreciation credit is to look for adjustments in the operating activities section. There is indeed a debit in the operating section to offset the initial credit.

Key concepts

Accumulated Depreciation

Accumulated depreciation plays a crucial role in financial accounting as it represents the total depreciation expense that has been recorded against a company's assets over time. This is not a direct measure of cash flow but impacts financial statements deeply. When a company accumulates this depreciation, it creates a contra asset account on the balance sheet. This effectively means that while assets' historical costs are not changed, the net book value is reduced.

This reduction helps investors understand the wear and tear on tangible assets such as machinery, equipment, or buildings. It's essential to note that accumulated depreciation does not reflect actual cash outflow; instead, it is an accounting practice. In the cash flow statement, it helps adjust net income for non-cash transactions when using the indirect method.

Operating Activities

Operating activities include all transactions related to the core business operations. This section of the cash flow statement reflects the cash generated or consumed by a firm's main operational activities. The fundamental aim is to show how much cash is created from a company's products or services.

Common items in operating activities are:

• Receipts from sales of goods and services
• Payments to suppliers and employees
• Amount related to interest payments and taxes
• Adjustments for non-cash items such as depreciation

Because accumulated depreciation is a non-cash transaction, any adjustments related to it appear here to align the net income with the actual cash flow.

Indirect Method

The indirect method is one of two ways to construct the cash flow statement, the other being the direct method. This approach starts with net income and makes adjustments for all non-cash transactions and changes in working capital items to derive cash flow from operating activities.

Key adjustments in the indirect method include:

• Adding back non-cash expenses like depreciation and amortization
• Adjusting for changes in inventory, accounts receivable, and payable
• Correcting for gains or losses that do not involve actual cash exchange

The primary advantage of the indirect method is its focus on reconciling net income with actual cash generated, providing a bridge between the income statement and cash flow statement.

Cash Flow Statement Adjustment

Adjustments in the cash flow statement are particularly crucial when applying the indirect method. They ensure that non-cash transactions, like depreciation adjustments, do not misrepresent a company's cash position.

When accumulated depreciation is recorded, adjustments must be made to reflect its nature as a non-cash item. In the cash flow statement, such non-cash expenses are added back to net income in the operating activities section. This prevents an understatement of cash flows generated by the business. Moreover, any credit to accumulated depreciation matched by a corresponding debit in the depreciation expense reflects as an important adjustment.

These adjustments enable stakeholders to gain a clearer picture of a company’s liquidity, assuring that the reported net cash flow is an accurate depiction of cash movement and not merely an accounting entry.