Final answer:
Depreciation expense, depletion expense, and amortization expense are added to net income in the operating activities section of the statement of cash flows when using the indirect method to reconcile non-cash expenses with actual cash flows and provide a clearer picture of a company's financial performance.
Step-by-step explanation:
Depreciation expense, depletion expense, and amortization expense are added to net income in the operating activities section of the statement of cash flows when using the indirect method because these expenses represent non-cash charges that need to be reconciled with actual cash flows. These expenses are subtracted from net income to account for their impact on profitability before being added back into the operating activities section. Including these expenses provides a clearer picture of a company's overall financial performance.
Here's why each of these expenses is added back:
Depreciation Expense:
Depreciation is a non-cash expense that represents the allocation of the cost of a tangible asset over its useful life. While depreciation reduces net income, it doesn't involve an actual outflow of cash during the period. Adding back depreciation to net income adjusts for this non-cash expense, providing a more accurate picture of the cash generated or used by the operating activities.
Depletion Expense:
Similar to depreciation, depletion is the allocation of the cost of natural resources (such as minerals or oil reserves) over time. Depletion expense is added back to net income in the operating activities section because, like depreciation, it is a non-cash charge that doesn't involve an immediate cash payment.
Amortization Expense:
Amortization is the process of spreading the cost of intangible assets (such as patents, trademarks, or goodwill) over their useful lives. Amortization expense is added back to net income because, like depreciation, it represents a non-cash charge. It reflects the accounting allocation of the intangible asset's cost over time, not an actual cash outflow.
By adding back these non-cash expenses, the statement of cash flows using the indirect method adjusts net income to provide a clearer picture of the cash flow from operating activities. The goal is to reconcile the differences between net income, which includes various non-cash items, and the actual cash generated or used by the company's core operating activities during a specific period.