In the indirect method of cash flows from operating activities, depreciation expense is treated as:

• A. A non-cash item added back to net income
• B. A cash outflow in operating activities
• C. A financing activity
• D. An investing activity

Answer: (A)

In the indirect method, you reconcile net income to cash provided by operating activities by starting with net income and adjusting for items that affected net income but not cash during the period. Depreciation expense fits this because it lowers net income on the income statement but does not involve an actual cash outflow in the period in which it’s recorded. Since the cash hasn’t left the company for depreciation, you add the amount back to net income when calculating cash flow from operating activities. This adjustment ensures the cash flow figure reflects the real cash generated by the core operations.

It’s not a cash outflow in operating activities, and it’s not a financing or investing activity, because those categories involve actual cash moves related to borrowing, equity, dividends, or the purchase and sale of long-term assets. Depreciation affects accounting records but not the cash position directly, which is why it’s added back in the indirect reconciliation.