Noncash Expense

A noncash expense is an expense that reduces reported profit on the income statement without requiring a cash payment in the same period. The most common examples are depreciation and amortization, which spread the cost of long-term assets that were paid for earlier over the years in which they are used. Other noncash expenses include impairment charges, share-based compensation, provisions for bad debts and some deferred tax expense.

Noncash expenses exist because of accrual basis accounting, which records costs when resources are consumed rather than when cash changes hands. They matter to analysts because they cause net income to differ from the cash a business actually generates, and they are the main items added back in the operating section of the statement of cash flows.

• Depreciation expense: the allocation of the cost of buildings, equipment and vehicles over their useful lives.
• Amortization expense: the same idea applied to intangible assets with finite lives, such as patents, software and acquired customer lists.
• Depletion expense: the allocation of the cost of natural resources such as oil, gas and minerals as they are extracted.
• Impairment charges: write-downs of assets, including goodwill, whose carrying amount exceeds what can be recovered.
• Share-based compensation: the fair value of stock options and restricted shares given to employees, expensed over the vesting period.
• Bad debt expense, unrealized losses on investments and losses on asset sales, which reduce profit without a matching cash outflow in the period.

A manufacturer reports net income of $2,000,000. Its income statement includes depreciation of $1,200,000, amortization of acquired intangibles of $300,000, share-based compensation of $400,000 and deferred tax expense of $100,000. Using the indirect method, cash flow from operations before working capital changes is:

Here $\text{Noncash expenses}$ are charges that reduced net income without using cash, and $\text{Working capital changes}$ adjust for movements in receivables, inventory and payables. Adding back $2,000,000 of noncash expenses gives $4,000,000 before working capital changes. If receivables and inventory grew by $600,000, operating cash flow is $3,400,000, considerably more than net income. This calculation appears in the statement of cash flows under cash from operating activities.

Noncash expenses reduce taxable income where tax rules allow them, so depreciation in particular creates a real cash benefit through lower taxes, often called a tax shield. They also explain why capital-intensive companies can report modest profits but strong cash flow. Measures such as EBITDA exclude depreciation and amortization for this reason.

However, "noncash" does not mean "not a real cost." Depreciation reflects money that was spent on assets in the past and will need to be spent again to replace them, which is why free cash flow deducts capital expenditure. Share-based compensation does not use cash, but it transfers value to employees by diluting existing shareholders, and many investors argue it should be treated like a cash wage. Impairments, though noncash when recorded, usually confirm that cash spent on an acquisition or investment earlier has been lost.

Analysts sometimes add back items that are not truly noncash, such as restructuring costs that will be paid in cash next year, or treat recurring share-based pay as if it were a one-off. Another mistake is double-counting: if an expense has already been excluded from an adjusted profit measure, it should not be added back again. Finally, noncash income items, such as unrealized gains or the equity-method share of an investee's profit, must be subtracted in the same way that noncash expenses are added, so that operating cash flow is not overstated.