How does depreciation affect financial statements?

Depreciation is the systematic allocation of an asset’s cost over its useful life. Accounting standards frame it as an allocation rather than a market revaluation. The Financial Accounting Standards Board establishes guidance under US generally accepted accounting principles, and the International Accounting Standards Board issues IAS 16 Property, Plant and Equipment under IFRS. Mary E. Barth at Stanford Graduate School of Business has written extensively about measurement choices and their effect on reported earnings, which highlights how depreciation method and useful-life estimates influence financial statement comparability and judgment.

Balance sheet effects and valuation
On the balance sheet, depreciation reduces the carrying amount of property, plant, and equipment through an accumulated depreciation contra account. This lowers reported total assets and therefore equity when accumulated depreciation increases relative to gross asset cost. The way managers estimate useful lives and residual values affects book values and key ratios such as return on assets and debt-to-equity. Territorial and cultural factors can influence those estimates: for example, public infrastructure in regions with frequent extreme weather may be assigned shorter useful lives, while some jurisdictions apply local regulatory lives for tax reporting that differ from accounting lives, creating permanent or temporary differences between tax bases and book bases of assets.

Income statement, cash flow, and tax consequences
Depreciation appears as an expense on the income statement and reduces operating profit and net income without reducing cash. Because it is a noncash expense, depreciation is added back in the operating section of the cash flow statement, which preserves cash flow while lowering taxable income. Tax authorities follow separate rules. The Internal Revenue Service prescribes depreciation methods for tax filings in the United States, most commonly the Modified Accelerated Cost Recovery System, which often accelerates deductions compared with straight-line accounting and thereby defers taxes. Differences between accounting depreciation and tax depreciation affect deferred tax assets and liabilities and can influence investment decisions, dividend policies, and capital budgeting.

Causes of change and broader consequences
Depreciation changes through events such as revisions of useful life estimates, changes in depreciation method, impairment, or disposal. Impairment rules require write-downs if recoverable amounts fall below carrying amounts, which can rapidly depress equity and signal operational or market distress. Environmental regulation, technological disruption, and shifts in consumer preferences can accelerate obsolescence; for example, stricter emissions rules can shorten the economic life of fossil-fuel plant assets, creating stranded-asset risk for companies and communities dependent on those industries. Financial covenant breaches driven by higher depreciation expense or impairment can have social consequences for employment and municipal revenues in regions dominated by asset-intensive industries.

Professional and investor use
Analysts and lenders adjust reported depreciation when comparing companies with different capital intensity or accounting policies. Textbook treatments and professional commentaries guide adjustment practices and disclosure expectations. Clear, consistent disclosures about depreciation method, useful lives, and significant changes are essential for transparency and for stakeholders to assess earnings quality, solvency, and long-term investment sustainability.