How does Depreciation affect tax liability?

• A. It increases tax liability
• B. It decreases tax liability
• C. It has no effect on tax liability
• D. It doubles tax liability

Answer: (B)

Depreciation affects tax liability by decreasing it. This occurs because depreciation is considered a non-cash expense that reduces taxable income. When a company computes its tax liability, it subtracts its expenses from its revenues to determine taxable income. By including depreciation as an expense, the overall taxable income is reduced, leading to a lower amount of income subject to taxation.

For example, if a business declares $100,000 in revenue but also claims $20,000 in depreciation, the taxable income would only be $80,000. This reduction in taxable income results in a decrease in the total tax owed by the company.

Understanding the relationship between depreciation and tax liability is essential in financial modeling and tax planning, as it allows companies to manage their cash flow more effectively. By maximizing depreciation deductions, a business can preserve more cash by deferring tax payments.