An increase in depreciation expense -- as with a hike in any operating expense -- negatively affects taxable income, also known as pretax income. To understand the subtleties of depreciation and its impact on profitability, it's helpful to make sense of cost allocation and the regulatory motive behind asset depreciation.
Depreciating an asset means spreading its worth over a specific number of years, a time frame finance people call "useful life" or "operating life." Public officials enact depreciation-related legislation to foster investments in long-term assets, the kind that spur economic activity and solidify a country's basic infrastructure -- think of roads and bridges -- and industrial fabric. Also known as fixed resources, long-term assets run the gamut from production machinery and heavy-duty office equipment to computer gear and real estate. To record a depreciation expense, a corporate bookkeeper debits the depreciation expense account and credits the accumulated depreciation account.
Higher Cost Allocation
When a company depreciates a fixed asset, accountants say the business is allocating the resource's cost over its useful life. An increase in depreciation expense may stem from the purchase of long-term assets or the reduction in the useful life that previously was applicable to a tangible asset. For example, a company buys equipment valued at $50,000 and wants to depreciate it evenly over five years. As a result, the annual depreciation expense equals $10,000, or $50,000 divided by five. If the business shortens the depreciation time span from five years to four, the annual expense becomes $12,500, or $50,000 divided by four.
To calculate taxable income, subtract a company's expenses from operating revenues. Expenses include everything from rent and litigation to office supplies, salaries, interest and machinery maintenance. Revenues come from selling goods, providing services or both. Taxable income is one step away from net income; you calculate the latter number by subtracting fiscal debts from taxable income.
A depreciation expense decreases taxable income, and both items are integral to a statement of profit and loss -- also known as an income statement, P&L, or report on income. Depreciation creates a numerical dent in the pretax income number, but that's not a bad thing for the reporting business because depreciation is a non-cash expense. The company doesn't pay for it but sees its taxable income go down -- a double winner because it ends up sending fewer tax dollars to the Internal Revenue Service owing to an expense for which it didn't dole out a cent in the first place.