How does depreciation impact financial statements?

Depreciation plays a significant role in financial statements, primarily by reducing taxable income, which directly affects the net income reported on the income statement. When a company records depreciation, it allocates a portion of the cost of an asset over several accounting periods. This annual expense decreases the company's taxable income, and subsequently, tax liability, leading to a lower net income when reported.

In addition to its impact on net income, the accumulated depreciation reflects on the balance sheet, reducing the book value of the company's assets over time. However, the critical factor here is the effect of depreciation on taxable income, as it directly influences profitability metrics and taxation obligations, which stakeholders closely analyze.

Choices that suggest depreciation increases total assets or has no impact on financial statements misrepresent its function. Also, stating that depreciation is only relevant for cash flow statements overlooks its broader implications on income and balance sheets. Therefore, the correct understanding is that depreciation reduces taxable income, impacting net income on the income statement significantly.