What is the effect of depreciation on the financial statements?

• A. It increases cash flow.
• B. It reduces net income via depreciation expense and reduces asset value through accumulated depreciation.
• C. It increases the asset's book value.
• D. It has no effect on financial statements.

Answer: (B)

Depreciation spreads the cost of a fixed asset over its useful life. It is a non-cash expense, so it doesn’t involve an actual cash outflow when recorded. On the income statement, depreciation reduces net income by the depreciation amount. On the balance sheet, depreciation is reflected through accumulated depreciation, a contra-asset account, which reduces the asset’s carrying amount over time. That means the asset’s book value declines as depreciation accumulates. Because it’s non-cash, depreciation is added back in the operating activities section of the cash flow statement when reconciling net income to cash flow, so it doesn’t decrease cash in the period. So, the effect is to lower net income and reduce the asset’s book value through accumulated depreciation.