Which statement about depreciation and tax shields is true?

Which statement about depreciation and tax shields is true?

• A. Depreciation has no impact on taxes.
• B. Depreciation provides a tax shield, reducing taxes payable.
• C. Depreciation increases taxes payable.
• D. Depreciation only affects asset values.

Answer: (B)

Depreciation creates a tax shield by reducing taxable income. When a business records depreciation, it subtracts that amount from revenue to determine taxable income, so the taxes owed are lowered. The savings, or tax shield, equal depreciation times the tax rate. That means depreciation boosts after-tax cash flow because you pay less in taxes without any actual cash outlay for the depreciation itself. For example, if depreciation is $10,000 and the tax rate is 30%, taxes payable drop by $3,000 correspondingly. This is why the statement about depreciation having no impact on taxes is false, and the idea that depreciation increases taxes payable is also incorrect. Depreciation does more than affect asset values; it changes cash flow by reducing taxes owed, which is the essence of the tax shield.

Depreciation creates a tax shield by reducing taxable income. When a business records depreciation, it subtracts that amount from revenue to determine taxable income, so the taxes owed are lowered. The savings, or tax shield, equal depreciation times the tax rate. That means depreciation boosts after-tax cash flow because you pay less in taxes without any actual cash outlay for the depreciation itself. For example, if depreciation is $10,000 and the tax rate is 30%, taxes payable drop by $3,000 correspondingly.

This is why the statement about depreciation having no impact on taxes is false, and the idea that depreciation increases taxes payable is also incorrect. Depreciation does more than affect asset values; it changes cash flow by reducing taxes owed, which is the essence of the tax shield.