What are the effects of depreciation?

The depreciation of assets such as equipment, buildings, furnishing, trucks, etc. causes a corporation's asset amounts, net income, and stockholders' equity to decrease. This occurs through an accounting adjusting entry in which the account Depreciation Expense is debited and the contra asset account Accumulated Depreciation is credited.

The amount of the annual depreciation that is reported on the financial statements is an estimate based on the asset's 1) cost, 2) estimated salvage value, and 3) useful life. Depreciation should be thought of as an allocation of the asset's cost to expense (and not as a valuation technique). In other words, the accountant is matching the cost of the asset to the periods in which revenues are generated from the asset.

The amount of the annual depreciation reported on the U.S. income tax return is based on the tax regulations. Since depreciation is a deductible expense for income tax purposes, the corporation's taxable income (and associated tax payments) will be reduced by its tax depreciation expense. (In any one year, the depreciation expense for taxes will likely be different from the amount reported on the financial statements.)

It should be noted that depreciation is viewed as a noncash expense. That is, the corporation's cash balance is not changed by the annual depreciation entry. (Often the corporation's cash is reduced for the asset's entire cost at the time the asset is acquired.)

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