Question

What impact does depreciation have on the net income/loss and also on tax reporting? Please provide examples

Answer 1

When a business purchases a physical asset with a useful life of longer than a year -- a building, for example, or a vehicle -- it doesn't report the full cost as an upfront expense. That's because accounting rules require that the expense be spread over the useful life of the asset. That's done through depreciation. Say your business bought a new truck for $30,000 cash, and it estimates that the truck has an estimated useful life of 10 years. Under the most common depreciation method, called the straight-line method, your company would report no upfront expense but a depreciation expense of $3,000 each year for 10 years.

Profit is simply all of a company's sales revenue and any other gains minus its expenses and any losses. A $3,000 depreciation expense, then, has the effect of reducing profit by $3,000. It's important to note, however, that "profit" is really just an accounting creation. With the truck in the previous example, your business spent the money upfront. All of the money was gone as soon as you bought the truck. But as far as your profit-and-loss calculations are concerned, you didn't really give up any value. Instead, you just traded $30,000 worth of cash for $30,000 worth of truck. As time passes and you "use up" that value by using the truck, you turn the cost into an expense through depreciation.

A depreciation expense has a direct effect on the profit that appears on a company's income statement. The larger the depreciation expense in a given year, the lower the company's reported net income -- its profit. However, becausedepreciation is a non-cash expense, the expense doesn't change the company's cash flow.