Which statement best describes the effect of depreciation on financial statements?

• A. Depreciation reduces net income on the income statement and is added back to cash flow from operations since it is non-cash
• B. Depreciation increases net income and cash flow from operations
• C. Depreciation has no effect on the income statement
• D. Depreciation only affects the balance sheet and not the cash flow

Answer: (A)

Depreciation is a non-cash expense that spreads the cost of a tangible asset over its useful life. On the income statement, it reduces pretax income and thus lowers net income because you’re recognizing an expense. Because no cash leaves the business when depreciation is recorded, the cash flow statement adds this non-cash expense back to net income in the operating activities section to reflect actual cash generated by operations. It also reduces the asset’s book value on the balance sheet through accumulated depreciation, but that is a non-cash adjustment rather than a cash outflow. So the correct description is that depreciation lowers net income and is added back to cash flow from operations since it is non-cash.