What is the effect of depreciation on financial statements?

Depreciation is a systematic allocation of the cost of a tangible fixed asset over its useful life. This process has significant implications for financial statements.

When depreciation is accounted for, it reduces the carrying amount of fixed assets on the balance sheet. This reduction reflects the wear and tear, decrease in value, or consumption of the asset over time. Concurrently, depreciation is also recorded as an expense in the income statement. This expense reduces net income for the period in which it is recognized, thus reflecting the cost associated with the use of the asset during the accounting period.

This dual effect is vital for accurately portraying a company's financial health and performance. By systematically reducing the asset value and recognizing a corresponding expense, financial statements provide a clearer picture of both asset values and the profit or loss generated by the company.

The other choices do not accurately reflect the implications of depreciation. For instance, stating that depreciation increases the carrying amount of fixed assets contradicts the fundamental principle of depreciation, as it is intended to reduce this carrying amount. Indicating that it has no effect on income statements overlooks the essential role of depreciation in expense recognition and profit calculation. Lastly, claiming that it increases net income by reducing tax payable misrepresents the nature of how depreciation affects net income