Depreciation results in:
Select one:
a. a decrease to net worth
b. a decrease to expenses
c. a decrease to cash
d. a decrease to liability
The correct answer and explanation is:
The correct answer is a. a decrease to net worth.
Explanation:
Depreciation is an accounting method used to allocate the cost of a long-term asset over its useful life. This reduces the book value of the asset over time. When depreciation is recorded, it affects both the income statement and the balance sheet, which in turn influences net worth.
- Impact on Net Worth: Depreciation decreases the asset’s value on the balance sheet, which directly reduces the total value of the company’s assets. Net worth (or shareholders’ equity) is calculated as the difference between a company’s assets and liabilities. A decrease in asset value due to depreciation leads to a reduction in net worth, as assets are reduced without an immediate change in liabilities.
- Impact on Expenses: Depreciation is a non-cash expense that is deducted from the income statement. It is recognized as an expense, but it does not result in an immediate outflow of cash. By recording depreciation, companies lower their taxable income, which ultimately reduces taxes. However, it does not directly lead to a decrease in actual expenses or cash outflows.
- Cash Flow: While depreciation is an expense that reduces taxable income, it does not directly affect cash flow. Depreciation does not result in cash being paid out, nor does it affect the company’s cash position directly. Instead, it reduces the book value of the asset.
- Liabilities: Depreciation does not decrease liabilities. Liabilities represent debts or obligations that the company owes, which are unrelated to depreciation. Depreciation only affects the asset side of the balance sheet.
In summary, depreciation leads to a decrease in the net worth of the company by reducing the book value of its assets, but it does not result in an immediate decrease in cash or liabilities.