Question: In the income statement presented above for the Liberto Company, net income was reported as
$100,000. That included depreciation expense (a noncash item) of $80,000 and a gain on the sale of equipment
(an investing activity rather than an operating activity) of $40,000. In applying the indirect method, how are
noncash items and nonoperating gains and losses removed from net income?
Answer: Depreciation is an expense and, hence, a negative component of net income. To eliminate a negative, it
is offset by a positive. Adding back depreciation serves to remove its impact from the reporting company’s net income.
The gain on sale of equipment also exists within reported income but as a positive figure. It helped increase profits
this period. To eliminate this gain, the $40,000 amount must be subtracted. The cash flows resulting from this transaction came from an investing activity and not an operating activity.
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