Which statement best describes depreciation and its impact on financial statements?

Which statement best describes depreciation and its impact on financial statements?

• A. Depreciation increases cash flow in the period it is recorded.
• B. Depreciation has no effect on profits or taxes.
• C. Depreciation is the systematic allocation of a fixed asset’s cost over its useful life, affecting profits and tax deductions.
• D. Depreciation is a cash expense that reduces cash on hand.

Answer: (C)

Depreciation is the systematic allocation of a fixed asset’s cost over its useful life. It is a non-cash expense, so it reduces reported profits on the income statement without a cash outlay in the period it’s recorded. At the same time, depreciation lowers taxable income, providing a tax deduction that reduces cash taxes payable. So, it affects both profits and taxes, while not being a cash expense itself. This combination is why the statement that describes depreciation as the systematic allocation of a fixed asset’s cost over its useful life, affecting profits and tax deductions, is the best fit. The idea that it increases cash flow directly in the period, or that it has no effect on profits or taxes, or that it is a cash expense, does not align with how depreciation works in accrual accounting and tax reporting.

Depreciation is the systematic allocation of a fixed asset’s cost over its useful life. It is a non-cash expense, so it reduces reported profits on the income statement without a cash outlay in the period it’s recorded. At the same time, depreciation lowers taxable income, providing a tax deduction that reduces cash taxes payable. So, it affects both profits and taxes, while not being a cash expense itself. This combination is why the statement that describes depreciation as the systematic allocation of a fixed asset’s cost over its useful life, affecting profits and tax deductions, is the best fit. The idea that it increases cash flow directly in the period, or that it has no effect on profits or taxes, or that it is a cash expense, does not align with how depreciation works in accrual accounting and tax reporting.