Question

What impact does depreciation have on the net income/loss and also on tax reporting? Please explain in your own words and provide examples

Answer 1

Depreciation is a period cost or fixed expense for a business. Depreciation is deducted from gross profit to calculate net income. Thus depreciation reduces net income or increases net loss.

As far as tax is concerned, depreciation expense is a deductible expenditure for tax purposes and thus provides a tax shield to the business. Depreciation provides tax benefit to the business. It reduces the tax payable by the company.

Suppose income before tax and depreciation is $100000 and depreciation is $10000. Further suppose the tax rate is 30%. If there is no depreciation, the tax to be paid would amount to $30000. Now depreciation provides a tax sheild.

Tax shield on depreciation = $10000 * 30% = $3000

The tax after deducting depreciation expense would be $27000 i.e. 30% * ($100000 - $10000)

Thus depreciation saves tax to the tune of $3000