Glencoe Entrepreneurship Finance Practice Exam

How do depreciation and taxes interact in financial statements?

Depreciation reduces accounting income; lowers taxable income; affects cash tax payment via tax shield. Depreciation increases accounting income; raises taxes. Depreciation has no effect on taxes. Depreciation only affects cash flow from investing activities.

Correct Answer:

Depreciation reduces accounting income; lowers taxable income; affects cash tax payment via tax shield.

Explanation:

Depreciation is a non-cash expense that reduces reported accounting income in the period it’s recorded. Because it’s deductible for tax purposes, it lowers taxable income and thus reduces the tax bill—creating a tax shield. This tax saving reduces cash taxes payable in the period, which improves cash flow. In the cash flow statement, depreciation is added back to net income under operating activities because no cash was actually spent on that expense, even though it lowered accounting income. So the effect is to lower accounting income, lower taxes, and increase operating cash flow via the tax shield.

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