IBankingFAQ
If a company incurs $10 (pretax) of depreciation expense, how does that affect the three financial statements?
First, the income statement: depreciation is an expense so operating income (EBIT) declines by $10. Assuming a tax rate of 40%, net income declines by $6. Second, the cash flow statement: net income decreased $6 and depreciation increased $10 so cash flow from operations increased $4. Finally, the balance sheet: cumulative depreciation increases $10 so Net PP&E decreases $10. We know from the cash flow statement that cash increased $4. The $6 reduction of net income caused retained earnings to decrease by $6. Note that the balance sheet is now balanced. Assets decreased $6 (PP&E -10 and Cash +4) and shareholder's equity decreased $6.
If depreciation is non-cash, explain how this transaction caused cash to increase $4.
The answer is that because of the depreciation expense, the company had to pay the government $4 less in taxes so it increased its cash position by $4 from what it would have been without the depreciation expense.
How does ??? impact the three financial statements?
Varieties of this question are some of the most common technical question asked in interviews today. This type of question attempts to test your understanding of how the three financial statements (income statement, balance sheet, cash flow statement) fit together. The most common variation of this question is how does $10 of depreciation affect the three financial statements (answered below). I've posted a few additional examples as well. To answer this question, take the 3 statements one at a time. My advice is to start with the income statement. Remember to tax-affect any change in revenue or costs (usually you will be told to assume a tax rate of 40%). Work your way down to net income. Next, tackle the cash flow statement. The first line of the cash flow statement is net income so start with that and work your way down to net change in cash. Last, take the balance sheet. The first line of the balance sheet is cash so again, start with that. The balance sheet must balance in order for your answer to be correct, which is why I recommend doing the balance sheet last. Remember the basic balance sheet equation: Assets = Liabilities + Shareholders' Equity. Don't get too stressed when asked a question like this. Just take it slowly, one statement at a time.