Walk the $10: depreciation through the statements
“Depreciation goes up by $10. Walk me through the three statements.”
It tests all three links at once, plus one subtle idea: a non-cash expense still changes cash, through taxes. Interviewers swap in other numbers and items, so the pattern matters more than the answer.
Depreciation lowers profit but costs no cash, so the only cash effect is the tax you save: cash rises by amount × tax rate.
Always start with the income statement
Depreciation is an expense, so pre-tax income falls by the full $10. Lower pre-tax income means a smaller tax bill: at a 25% rate you pay $2.50 less tax. Net income therefore falls by only $7.50, not $10.
Then the cash flow statement
Start from net income, down $7.50. But no cash left the building for depreciation: the machine was paid for years ago. So you add the $10 back. Net effect: cash is up $2.50, which is exactly the tax saving.
Finish with the balance sheet, and make it balance
Assets: cash is up $2.50, and PP&E is down $10 because the asset is now more used up. Total assets: down $7.50. Liabilities and equity: retained earnings fall with net income, down $7.50. Both sides moved by the same amount, so it balances.
Predict it: up, down, or the same?
- 1IS: pre-tax −$40; tax saving 21% × 40 = $8.40; net income −$31.60.
- 2CFS: −$31.60 + $40 add-back = cash +$8.40.
- 3BS: cash +$8.40, PP&E −$40 → assets −$31.60; retained earnings −$31.60.
If the company pays no tax (it has losses), the tax saving is zero, so cash doesn't move at all. Interviewers love this twist.
The same shape covers a whole family of questions: stock-based compensation, inventory write-downs, accrued expenses and impairments. Each is a non-cash hit to profit, added back on the cash flow statement. What changes is which balance sheet line absorbs it, and whether it's tax-deductible.
Say it like this
On the income statement, pre-tax income falls by $10, and at a 25% tax rate net income falls by $7.50. On the cash flow statement, net income is down $7.50 but depreciation is non-cash, so I add back the $10 and cash ends up $2.50 higher. On the balance sheet, cash is up $2.50 and PP&E is down $10, so assets are down $7.50; retained earnings are down $7.50 from net income, so both sides fall by $7.50 and it balances.
Traps to avoid
- ✕Saying net income falls by $10. Forgetting the tax effect is the most common miss.
- ✕Saying cash falls. Depreciation itself costs no cash; the tax shield makes cash go up.
- ✕Forgetting PP&E on the balance sheet, then wondering why it doesn't balance.
What they'll ask next
›What if it's stock-based compensation instead?
Same IS and CFS. On the balance sheet the tax saving lands in cash, and equity changes twice: common stock/APIC up by the full amount, retained earnings down by the after-tax amount.
›What if depreciation goes down by $10?
Run it in reverse: net income +$7.50, the add-back shrinks by $10, so cash falls $2.50. PP&E is $10 higher than it otherwise would be.
›Why is depreciation tax-deductible but not a cash cost?
The cash was spent upfront as capex. Depreciation spreads that cost over the asset's life for both profit and tax purposes, so the deduction arrives later while the cash went out earlier.
Check yourself
Depreciation goes up by $10. The tax rate is 25%. By how much does net income change?
Use a minus sign for a decrease.
Put it all together
Turn a year of real-world events into an income statement, a cash flow statement and a balance sheet that balances.