Impact of depreciation on CFO

CFA Level I FRA
#1

Slightly confused with this question:

If depreciation expense was understated in a company’s financials, CFO presented under the indirect method assuming a tax-free environment is most likely:

A. Accurately stated

B. Understated

C. Overstated

Answer: A --> A change in depreciation has no impact on cash flow whatsoever. An increase in deprecation would reduce net income (the starting point of the indirect cash flow statement) but have no effect on total cash flow.

I know depreciation is a non-cash expense but doesn’t it still affect CFO because it gets added back during the calculation? Is it because the question mentioned a “tax-free environment”?

#2

in the indirect method - you start with NI add back depreciation.

so with a higher depreciation expense - net income would be lower - but the same depreciation gets added back so net impact is 0.

#3

how do you keep straight what you should be adding or subtracting in the indirect method and direct method? the book seems to treat them differently

#4

@ OP:

It’s been a while since I reviewed this much accounting, but I think you are right. A is correct because it is tax free.

Had it been tax affected, an understated depreciacion will result in an understated CFO due greater taxes

#5

Well lets be clear that depreciation in itself wont affect cashflow as you yourself said as well as the rules say its non-cash hence its added back to net income. But what depreciation does affect is the tax amount which goes into the cash flow as an outflow. An understated dep expense would result in higher net income resulting in a higher tax amount . Since the depreciation is added back to net income regardless if its under or overstated, it will balance out into the same figure under in the CFO in either case after the addition, because understated dep means overstated net income and vice versa. But the figure that will be different will be the tax figure in the CFO.

Understated dep will lead to higher tax thereby understating CFO, and vice versa.

But since the question mentions a tax free environment, so the tax amount is out of the equation.