SAP Business One Certification Practice Exam

Does depreciation affect a company's balance sheet as an expense?

1. Yes, it increases liabilities

2. No, it only affects cash flow

3. Yes, it reduces overall equity

4. No, it has no impact

The correct answer is: Yes, it reduces overall equity

Depreciation is a method used to allocate the cost of tangible assets over their useful lives. As an asset depreciates, its value on the balance sheet decreases, leading to a corresponding reduction in the overall equity of the company. This happens because assets are listed on the balance sheet at their book value, which is affected by accumulated depreciation. When depreciation is recorded as an expense on the income statement, it reduces net income, which in turn reduces retained earnings, a component of equity on the balance sheet. Thus, the recognition of depreciation directly impacts the financial position of the company by lowering its equity, making the assertion that depreciation reduces overall equity a correct statement. The other choices do not accurately reflect the relationship between depreciation and the balance sheet. For instance, while depreciation does impact cash flows, it does not solely affect them, as it also impacts the equity line in the balance sheet. Similarly, depreciation does not increase liabilities; instead, it is an expense that arises from the use of an asset, thus affecting asset and equity valuations rather than liabilities.