How Does Depreciation Affect an Owner's Equity?

Depreciation is the decrease in value that assets undergo as a direct consequence of their usage in normal business activities. It is accounted for as an expense incurred once a month for each asset that can be depreciated. Depreciation has an indirect impact on owner's equity through its influence on costs on the income statement. Higher depreciation leads to higher cost, which leads to lower income, which leads to lower retained earnings added to owner's equity.

An income statement reports a business's revenues, costs and income or loss at the end of an accounting time period, whether that is a month or a year. More revenues than costs means that the business has made a profit, which is reported as income, while the reverse means that it has suffered a loss.

Depreciation is accounted for as an expense. Higher depreciation leads to smaller incomes and/or bigger losses, and is included as part of the period's income or loss on the business's statement of retained earnings.

The statement of retained earnings reports the changes in a business's retained earnings during one accounting time period. Retained earnings is the portion of a business's income that is retained for further use by the business rather than paid out to its owners and shareholders. Changes in retained earnings include gains and losses not included on the income statement, dividends paid out and the period's net income.

Retained earnings are considered part of owner's equity, which stands for the claim that a business's owners have on its assets after all liabilities are deducted. Since depreciation is an important expense on the income statement, it impacts owner's equity through net income, which in turn impacts retained earnings. The higher the depreciation expense, the lower the net income, the lower the retained earnings and thus the lower the owner's equity.