Depreciation is considered a non-cash transaction. This is because it is an adjustment to net income that allows companies to write off a certain amount of the asset's value in the making of a product or service. Stockholders' equity is used to identify the equity in the company. A higher net income increases stockholders' equity through retained earnings.
Depreciation expense is a calculation used in determining adjusted net income for tax purposes. The Internal Revenue Service and the Securities and Exchange Commission require companies to publish one net income statement. As a result, companies publish the one that provides a lower net income amount. The net income statement is not made with the investor in mind. Only the most savvy investor adds back depreciation to net income in order to determine real operating income.
Balance Sheet Equation
While depreciation expense can be found on the income statement, stockholders' equity is found on the balance sheet. It represents that part of company assets that are owned outright and not through borrowed funds. The balance sheet equation is, assets equals liabilities plus stockholders' equity. At an extreme, if a company has $0 stockholders' equity, it means that all assets are paid for with borrowed funds and vice versa.
Stockholders' equity includes investment funds received from issuing stock and retained earnings from sales generated every year. A high net income translates into a high retained earnings, which also increases stockholders' equity, especially if the cash received is used to pay off liabilities.
Since depreciation is not a real cash event, it is hard to understand how it really affects the equity in a company. On paper, however, and according to generally accepted accounting principles, a higher depreciation expense lowers stockholders' equity and vice versa. That is, they have an inverse relationship.
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