How does depreciation affect a company's financial statements?

Depreciation affects a company's financial statements by reducing taxable income. When a company records depreciation, it allocates the cost of an asset over its useful life, reflecting wear and tear, and economic use of the asset. This allocation is recorded as an expense on the income statement.

By increasing expenses through depreciation, the company lowers its taxable income. Since taxes are calculated on net income, a higher expense due to depreciation means the company pays less in taxes, which can positively impact cash flow by retaining more earnings.

Understanding this concept is important because it illustrates how non-cash expenses like depreciation can influence financial outcomes, including tax obligations, without having a direct effect on cash flow in the period it is recorded.