What happens to the three statements when depreciation increases by $10?
What this question is really asking
This is the most-asked accounting question in banking recruiting, and it's asked in almost exactly these words. It's a mechanical question with a right answer, which means there's no credit for style — only for getting the numbers right, in the right order, and closing with a balance sheet that balances.
Learn it as a sequence rather than a set of facts. Income statement, then cash flow statement, then balance sheet, every time. The order isn't a preference; each statement feeds the next.
How to structure your answer
State your tax rate first. Say "assuming a 40% tax rate" and the whole answer follows cleanly. Interviewers commonly use 40% because the arithmetic is easy, though you can note that a realistic rate today is closer to 25%. Either is fine — what matters is that you name it before you start.
Income statement. Depreciation rises by $10, so operating income falls by $10. Pre-tax income falls by $10. At a 40% rate, taxes fall by $4, so net income falls by $6.
Cash flow statement. Start from net income, down $6. Add back the $10 of depreciation, because it's a non-cash charge. Cash from operations rises by $4, and with no other changes, cash at the bottom rises by $4.
Balance sheet. Cash is up $4. PP&E is down $10 from the additional depreciation. Assets are therefore down $6. On the other side, retained earnings fall by $6 because net income fell by $6. Both sides move by $6, and the balance sheet balances.
Then say why cash went up. This is the sentence that shows you understand rather than memorised: depreciation is a non-cash expense, but it's tax deductible, so the only real cash effect is the tax saving of $10 × 40% = $4.
Always close the loop out loud. "…and the balance sheet balances" is the expected ending. Stopping before it makes it sound like you're unsure whether it does.
What the interviewer is testing
Whether you know the sequence. Income statement first, cash flow second, balance sheet last. Candidates who start with the balance sheet almost always get lost, because they don't yet have the net income figure they need.
Whether you understand the tax shield. The entire reason cash increases is that a non-cash charge reduced taxable income. If you can state that in one sentence, the follow-ups become easy.
Whether you can handle a changed assumption. The standard probe is: what if the tax rate were zero? Then net income falls by $10, the add-back is $10, cash is unchanged, PP&E is down $10 and equity is down $10. Still balances, and no cash benefit — which makes the point about the tax shield for you.
Whether you can extend it. Common extensions include a $10 write-down, $10 of capex instead of depreciation, or an increase in a non-cash charge like stock-based compensation. The method is identical every time.
Frequently asked
Which statement do you start with?
The income statement, always. It gives you net income, which is the starting line of the cash flow statement, which gives you the cash figure you need for the balance sheet. Starting anywhere else means working with numbers you have not derived yet.
What if the tax rate is zero?
Net income falls by the full $10, you add back $10 on the cash flow statement, and cash is unchanged. PP&E falls $10 and retained earnings fall $10. It still balances, and it shows the cash benefit comes entirely from the tax shield.
Why does cash increase when an expense increases?
Depreciation is non-cash — no money leaves the business. But it is tax deductible, so taxes fall by $10 multiplied by the tax rate. That tax saving is the only real cash movement, and it is positive.
What if it were $10 of capex instead?
Capex is a cash outflow in investing activities, not an expense. The income statement is unchanged, cash falls $10, and PP&E rises $10. Assets net to zero and equity is unchanged. A useful contrast to have ready.
Does PP&E go down or does accumulated depreciation go up?
Both descriptions are correct. Accumulated depreciation is a contra-asset, so a $10 increase in it reduces net PP&E by $10. Saying net PP&E falls by $10 is the cleaner way to phrase it in an interview.
Common mistakes
Not stating the tax rate. Every number downstream depends on it. Say it first.
Forgetting the add-back on the cash flow statement. The single most common error, and it breaks the balance sheet.
Saying cash goes down. An expense went up, so the instinct is that cash falls. It doesn't — the expense is non-cash and it saves tax.
Doing the balance sheet before the cash flow statement. You need the cash figure first. Going out of order is how candidates end up with an unbalanced answer they can't fix live.
Forgetting retained earnings. Net income flows to equity. Candidates who adjust only the asset side get a $6 imbalance and freeze.
Sign errors under pressure. Slow down. Say each number as you go rather than racing to the end.
Not closing with the balance check. It's expected, it takes two seconds, and it's the difference between an answer that sounds complete and one that trails off.
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