Why does depreciation affect cash balance?

Why does depreciation affect cash balance?

• A. It is a non-cash expense that increases cash immediately.
• B. It is tax-deductible, reducing taxes paid and preserving cash.
• C. It creates a cash outflow when recorded.
• D. It has no effect on cash balance.

Answer: (B)

Depreciation lowers taxable income, which reduces the amount of taxes you owe. Since taxes are paid with cash, this tax saving preserves cash and can improve the cash balance. At the same time, depreciation is a non-cash expense: it reduces accounting profit without using cash in the period it’s recorded, which is why, on the cash flow statement, depreciation is added back to net income to reflect that no cash was spent. The other statements are less accurate: depreciation doesn’t increase cash immediately, it doesn’t create a cash outflow when recorded, and it does have a cash-effect via lower taxes.

Depreciation lowers taxable income, which reduces the amount of taxes you owe. Since taxes are paid with cash, this tax saving preserves cash and can improve the cash balance. At the same time, depreciation is a non-cash expense: it reduces accounting profit without using cash in the period it’s recorded, which is why, on the cash flow statement, depreciation is added back to net income to reflect that no cash was spent. The other statements are less accurate: depreciation doesn’t increase cash immediately, it doesn’t create a cash outflow when recorded, and it does have a cash-effect via lower taxes.