In Year 2, where Book Depreciation equals Tax Depreciation (both 10), what is the ending Cash impact described in the example?

In Year 2, where Book Depreciation equals Tax Depreciation (both 10), what is the ending Cash impact described in the example?

• A. Cash increases by 4
• B. Cash decreases by 4
• C. Cash increases by 10
• D. Cash unchanged

Answer: (A)

Depreciation creates a tax shield: it reduces taxable income, so the taxes you owe drop by depreciation amount times the tax rate. When book depreciation equals tax depreciation in a given year, there’s no timing difference, so no deferred tax adjusts at year end. The cash effect you see comes solely from the tax shield. In this year, depreciation is 10 and the tax rate is 40%, so taxes are reduced by 4, which increases cash by 4. The depreciation itself is non-cash, but the cash impact is the tax savings it generates, hence ending cash rises by 4.

Depreciation creates a tax shield: it reduces taxable income, so the taxes you owe drop by depreciation amount times the tax rate. When book depreciation equals tax depreciation in a given year, there’s no timing difference, so no deferred tax adjusts at year end. The cash effect you see comes solely from the tax shield. In this year, depreciation is 10 and the tax rate is 40%, so taxes are reduced by 4, which increases cash by 4. The depreciation itself is non-cash, but the cash impact is the tax savings it generates, hence ending cash rises by 4.