How does depreciation affect financial statements?

Depreciation is an accounting method used to allocate the cost of tangible assets over their useful lives. When considering its impact on financial statements, we find that it reduces the book value of assets on the balance sheet, reflecting the wearing down of these assets over time. This decrease is essential as it provides a more accurate picture of the asset's value, taking into account its usage and aging.

On the income statement, depreciation is recorded as an expense, which directly reduces taxable income. Reducing taxable income lowers the amount of taxes a business needs to pay, thus having a significant impact on the company's overall financial health. This dual effect—decreasing the asset's book value and reducing taxable income—illustrates why understanding depreciation is crucial for accurately interpreting financial statements.

By recognizing the way depreciation affects both the balance sheet and the income statement, businesses can present a more realistic view of their financial status, ensuring stakeholders have the necessary information to make informed decisions.