If Net Income falls by $6 due to an increase in Depreciation, how does that affect Shareholders' Equity?

• A. Increases Shareholders' Equity
• B. Decreases Shareholders' Equity
• C. No effect on Shareholders' Equity
• D. Shareholders' Equity is unaffected

Answer: (B)

When net income falls due to an increase in depreciation, it results in a decrease in retained earnings, which is a component of shareholders' equity. Depreciation is a non-cash expense that reduces net income on the income statement. As net income decreases, the retained earnings component of shareholders' equity also decreases, leading to an overall decrease in total shareholders' equity.

Since retained earnings reflect the cumulative earnings of a company that have not been distributed to shareholders as dividends, a decline in net income from increased depreciation causes retained earnings to drop. This is because, at the end of the accounting period, the lower net income means that there are fewer profits retained in the business. Thus, the correct understanding of the relationship between net income, depreciation, and shareholders' equity highlights that an increase in depreciation, thereby reducing net income, will negatively impact shareholders' equity by decreasing retained earnings.