How does depreciation impact financial statements?

Depreciation impacts financial statements primarily by reducing taxable income and asset value. When a business claims depreciation, it allocates the cost of a tangible asset over its useful life. This allocation is recorded as an expense on the income statement, which effectively lowers the net income for that period. As a consequence, since taxable income is derived from net income, the recognition of depreciation can lead to a lower tax liability for the company.

On the balance sheet, the accumulated depreciation reduces the book value of the asset. This reflects the decrease in value of the asset over time due to wear and tear, obsolescence, or other factors. Therefore, the correct answer illustrates how depreciation not only influences the income statement by impacting net income but also directly affects the balance sheet by lowering the asset's recorded value. This dual impact is essential for understanding the financial health of a business, as it affects profitability indicators and the reported value of the company’s assets.