Depreciation Increases by $10: Walk Through the Three Statements

Assume depreciation expense increases by $10, with no change in revenue, operating costs other than depreciation, capital expenditures, debt, or working capital. Also assume the company has taxable income and a 25% tax rate, so the additional depreciation produces a current tax benefit.

Depreciation is a non-cash expense that allocates the cost of property, plant, and equipment, or PP&E, over its useful life. It reduces reported earnings and the carrying value of PP&E, but the expense itself does not represent a current-period cash payment.

Revenue is unchanged. Cash operating expenses are also unchanged, but depreciation expense increases by $10. As a result, operating income, also called EBIT, decreases by $10.

Assuming interest expense and non-operating items do not change, pre-tax income decreases by $10. At a 25% tax rate, income tax expense decreases by $2.50 because the company has $10 less taxable income.

Net income therefore decreases by $7.50: the $10 pre-tax decline minus the $2.50 tax benefit.

• Revenue: no change
• Depreciation expense: increases by $10
• EBIT: decreases by $10
• Pre-tax income: decreases by $10
• Taxes: decrease by $2.50
• Net income: decreases by $7.50

The cash flow statement begins with net income, which is down $7.50. In cash flow from operating activities, add back the full $10 of depreciation because it reduced net income without using cash in the current period.

With no other operating adjustments, cash flow from operations increases by $2.50. Cash flow from investing is unchanged because the question changes depreciation, not capital expenditures. Cash flow from financing is also unchanged.

The net change in cash is therefore an increase of $2.50, reflecting the tax savings created by the additional depreciation.

• Net income: decreases by $7.50
• Depreciation add-back: increases by $10
• Cash flow from operations: increases by $2.50
• Cash flow from investing: no change
• Cash flow from financing: no change
• Ending cash: increases by $2.50

On the asset side, cash increases by $2.50 from the cash flow statement. Net PP&E decreases by $10 because accumulated depreciation increases by $10. Total assets therefore decrease by $7.50.

On the liabilities and equity side, liabilities are unchanged under the simplified assumptions. Retained earnings decreases by $7.50 because lower net income flows into retained earnings, assuming no change in dividends. Total shareholders’ equity falls by $7.50.

The balance sheet remains balanced: assets decrease by $7.50, while liabilities plus equity also decrease by $7.50.

• Cash: increases by $2.50
• Net PP&E: decreases by $10
• Total assets: decrease by $7.50
• Liabilities: no change
• Retained earnings: decreases by $7.50
• Total liabilities and equity: decrease by $7.50

Move through the statements in order: income statement, cash flow statement, then balance sheet. Explain why each change occurs and finish by proving that the balance sheet balances.

If there is no tax benefit—for example, the company cannot currently use the tax deduction—net income falls by the full $10. Adding back $10 of depreciation leaves cash unchanged, while PP&E and retained earnings each decline by $10. More advanced cases involving different book and tax depreciation may create deferred taxes, but do not introduce that complication unless the interviewer asks.

• A $10 depreciation increase reduces net income by $7.50 at a 25% tax rate.
• Adding back the non-cash expense causes cash to increase by the $2.50 tax benefit.
• Cash rises by $2.50 and net PP&E falls by $10, reducing total assets by $7.50.
• Retained earnings falls by $7.50, keeping the balance sheet balanced.