DEPRECIATION AND CASH FLOW
A colleague is about to make a presentation to the management group regarding a $2 million capital investment proposal. She is quite sure that the management group will press her to identify a new source of financing to support the proposed investment. She shows you the operating activities section of the company’s most recent statement of cash flows. (Amounts are in thousands of dollars.)
Net Income $84,597
Depreciation expense 10,501
Decrease in accounts receivable 4,157
Increase in wages payable 2,924
Your colleague is aware that there are a variety of methods acceptable under GAAP by which depreciation expense can be computed. Further, she knows that the company currently uses a very conservative method that results in low depreciation expense, especially in the early years of an asset’s life. Your colleague is going to suggest that the firm use a more aggressive depreciation policy that will result in higher depreciation expense for the next several years. Says she, “The higher depreciation expense will generate more cash from operating activities. According to the cash flow statement here, adding back greater depreciation expense will result in more cash provided in operating activities. See?” Assume it’s quite reasonable that the firm use a more aggressive depreciation method.
A. What format is this company using to prepare the statement of cash flows?
B. Do you agree with your colleague’s thinking? Why or why not?
C. Construct a numerical example to prove your argument.
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