Depreciation reduces Pre-Tax Income.

• A. True
• B. False
• C. It increases Net Income
• D. It has no effect on taxes

Answer: (A)

Depreciation lowers the amount of income reported before taxes are applied. As a non-cash expense, it reduces pretax income by the depreciation amount, which means the company shows less income on the income statement before taxes are calculated. Since taxes are based on that pretax income, lowering it reduces the tax expense as well (a tax shield). However, net income still falls because you recorded an expense and only part of the tax savings offsets that, so net income ends up lower by roughly depreciation times (1 minus the tax rate). For example, if pretax income is 100, tax rate is 30%, and depreciation is 20, the new pretax income is 80, taxes are 24, and net income is 56 instead of 70. Thus, depreciation reduces pretax income, and the statement is true. It does affect taxes via a lower tax expense and does not increase net income.