What effect does depreciation have on a company's financial statements?

Depreciation has a significant impact on a company's financial statements primarily through its effect on profit and tax liabilities. When a company records depreciation, it reduces the book value of its fixed assets over time, reflecting the consumption or wear and tear of those assets. This reduction is recognized as an expense on the income statement, which directly decreases the company's reported profit for that period.

The decrease in profit due to depreciation also affects tax liabilities, as the lower net income results in a lower taxable income. Therefore, businesses benefit from tax savings because they can deduct the depreciation expense from their revenues, which ultimately lowers their tax obligations.

This mechanism not only provides an accurate representation of an asset's value over time but also serves as a strategic financial tool to manage taxable income. It’s important to understand that while depreciation affects profit and taxes, it does not involve an actual cash outflow, which distinguishes it from other expenses. As a result, the tax saving from depreciation can improve cash flow indirectly, but its primary and immediate effect is on profit and tax liabilities.