Depreciation, a non-cash expense, indirectly affects total equity by reducing net income, which in turn reduces retained earnings, a component of equity.
Understanding the Relationship
- Depreciation Expense: Depreciation represents the gradual decline in the value of a tangible asset over its useful life. It's recorded as an expense on the income statement.
- Net Income: Depreciation expense reduces net income, the profit remaining after all expenses are deducted from revenue.
- Retained Earnings: Net income contributes to retained earnings, which is the accumulated profit that a company has kept over time.
- Total Equity: Total equity represents the owners' stake in the company, including retained earnings, contributed capital, and other equity components.
Impact on Total Equity
- Reduced Retained Earnings: As depreciation reduces net income, it also reduces retained earnings. This, in turn, lowers the total equity of the company.
- No Direct Cash Impact: Depreciation is a non-cash expense, meaning it doesn't involve an actual cash outflow. It's simply an accounting method to reflect the asset's declining value.
Example
Imagine a company with a $10,000 net income before depreciation. If the company records $2,000 in depreciation expense, its net income will be reduced to $8,000. This $8,000 will be added to retained earnings, resulting in a lower total equity compared to a scenario without depreciation.
Key Points
- Depreciation indirectly affects total equity through its impact on net income and retained earnings.
- It's a non-cash expense, so it doesn't involve an actual cash outflow.
- It helps to accurately reflect the declining value of assets over time.
