Utah Contractor Practice Exam

How is depreciation best defined?

1. A fixed liability

2. An asset subject to tax for 5 years

3. Profit that increases taxes for 5 years

4. An expense that decreases taxes

The correct answer is: An expense that decreases taxes

Depreciation is best defined as an expense that decreases taxes because it represents the allocation of the cost of tangible assets over their useful lives. When a business purchases an asset, such as equipment or property, the cost of that asset is not fully expensed in the year of purchase. Instead, it is depreciated over several years. This reduction in taxable income allows businesses to reflect the wearing out or usage of their assets over time, reducing their overall tax obligation. As the depreciation expense is deducted from revenue when calculating taxable income, it effectively lowers the amount of taxes that a business must pay. This accounting treatment aligns with the matching principle in accounting, ensuring that expenses are matched with revenues generated by the asset, thus giving a more accurate representation of financial performance. The other options do not accurately capture the concept of depreciation. They either mischaracterize its nature or how it interacts with taxes and liabilities. Understanding depreciation's role in tax reduction is crucial for contractors and business owners as it impacts cash flow and investment planning.