Question

Which of the following statements is CORRECT?

1) The more depreciation a firm reports, the higher its tax bill, other things held constant.
2) People sometimes talk about the firm's cash flow, which is shown as the lowest entry on the income statement, hence it is often called "the bottom line."
3) Depreciation reduces a firm's cash balance, so an increase in depreciation would normally lead to a reduction in the firm's cash flow.
4) Operating income is derived from the firm's regular core business. Operating income is calculated as Revenues less Operating costs. Operating costs do not include interest or taxes.
5) Depreciation is not a cash charge, so it does not have an effect on a firm's reported profits.

Answer 1

The only correct statement is number 4, which defines operating income as revenues less operating costs, excluding interest and taxes. Other statements either confuse cash flow with bottom line or misunderstand the role of depreciation in financial statements and tax calculations.

Step-by-step explanation:

The correct statement among the options provided is: Operating income is derived from the firm's regular core business. Operating income is calculated as Revenues less Operating costs. Operating costs do not include interest or taxes. This corresponds to statement number 4. Now, let's address why the other statements are incorrect:

1) More depreciation actually lowers the tax bill because depreciation is a non-cash expense that reduces taxable income.

2) The term 'bottom line' actually refers to net income or profit, not cash flow. Cash flow is related yet different and is concerned with the actual movement of money into and out of the business.

3) Depreciation does not reduce a firm's cash balance directly as it is a non-cash charge that accounts for the wear and tear of assets over time.

5) Depreciation, while not a cash charge, definitely has an effect on a firm's reported profits since it is deducted from revenue to determine taxable income.