What this question is really asking
This is the most-asked accounting question in banking recruiting, and it is asked in almost exactly these words.
It is a mechanical question with one right answer. There are no marks for style — only for getting the numbers right, in the right order, and finishing with a balance sheet that balances.
The good news is that once you understand why the numbers move, you never have to memorise it again. And the same method works for every variation they can throw at you.
How to structure your answer
First, what is depreciation?
If you are new to accounting, start here.
Say a company buys a delivery van for $50,000. The van will last about five years.
It would be misleading to record the whole $50,000 as a cost in year one. The van helps the business for five years, so the cost should be spread across those five years.
So accounting records $10,000 as a cost each year for five years. That yearly charge is called depreciation.
Here is the crucial part: the money left the company when it bought the van. No cash goes out in years two, three, four or five. The depreciation charge is just an accounting entry.
That is why depreciation is called a non-cash expense. It reduces profit on paper without any money moving.
Now you can understand what happens when it goes up by $10.
Say your tax rate first
Before any numbers, say this out loud:
"Assuming a 40 percent tax rate…"
Interviewers commonly use 40 percent because the arithmetic is easy. A more realistic rate today is around 25 percent. Either is fine. What matters is that you name it, because every number that follows depends on it.
Step 1: The income statement
Depreciation is a cost. So costs go up by $10.
- Operating profit falls by $10
- Profit before tax falls by $10
- Tax falls by $4 (that is 40 percent of $10 — you pay less tax because you made less profit)
- Net income falls by $6
That last number is the one you carry forward.
Step 2: The cash flow statement
Always second. Never skip to the balance sheet.
The cash flow statement starts with net income and adjusts it back into real cash.
- Start with net income: down $6
- Add back depreciation: up $10
Why add it back? Because no cash actually left the company. It is an accounting entry, not a payment. The cash flow statement only cares about real money.
- Cash from operations: up $4
- Nothing else changed, so cash at the bottom goes up by $4
Step 3: The balance sheet
Now you have everything you need.
On the assets side:
- Cash: up $4 (from the cash flow statement)
- Property, plant and equipment: down $10 (the assets are one year older and worth less)
- Total assets: down $6
On the other side:
- Retained earnings: down $6
Retained earnings are the total profits the company has kept over the years. Net income fell by $6, so retained earnings fall by $6.
- Total liabilities and equity: down $6
Both sides fell by $6. And the balance sheet balances.
Say those last five words out loud. Interviewers expect them, and stopping before them makes it sound like you are not sure.
Now explain why cash went up
This is the sentence that separates understanding from memorising:
"Cash went up because depreciation is a non-cash expense, but it is still tax deductible. So the only real cash effect is the tax saving — $10 times the 40 percent tax rate, which is $4."
That is the whole logic in one breath. A cost that costs no money, but still lowers your tax bill, leaves you with more cash than before.
The variations they will throw at you
Once you can do the base case, they change something. The method never changes — income statement, cash flow, balance sheet, confirm it balances.
"What if the tax rate were zero?"
- Income statement: net income falls the full $10, because there is no tax saving
- Cash flow: start at −$10, add back $10, cash does not change at all
- Balance sheet: PP&E down $10, retained earnings down $10. Balances.
This variation proves the point beautifully. With no tax, there is no benefit at all. All the cash upside came from the tax shield.
"What if it were $10 of capex instead?"
Capex means buying an actual asset — real money leaving the building.
- Income statement: no change. Buying an asset is not an expense.
- Cash flow: cash falls $10 under investing activities
- Balance sheet: cash down $10, PP&E up $10. Assets net to zero. Equity unchanged. Balances.
"What about a $10 write-down?"
A write-down means an asset turned out to be worth less than the books say. Same shape as depreciation: a non-cash charge.
The numbers work out identically to the depreciation case.
"What about $10 of stock-based compensation?"
Paying employees in shares instead of cash. Another non-cash expense.
Same as depreciation on the income statement and cash flow statement. On the balance sheet, equity goes up rather than assets going down.
Saying it out loud
"Assuming a 40 percent tax rate.
On the income statement, depreciation goes up $10, so pre-tax income falls $10, tax falls $4, and net income falls $6.
On the cash flow statement, you start with net income down $6, then add back the $10 of depreciation because it is non-cash. So cash goes up $4.
On the balance sheet, cash is up $4 and PP&E is down $10, so assets fall $6. Retained earnings fall $6 because net income fell $6. Both sides fall by the same amount, and the balance sheet balances.
Cash went up because depreciation lowers your tax bill without any money leaving — the $4 is the tax saving."
What the interviewer is really checking
Do you know the sequence?
Income statement, then cash flow statement, then balance sheet. Candidates who start with the balance sheet almost always get lost, because they do not yet have the net income or cash figures they need.
Do you understand the tax shield?
The whole reason cash goes up is that a non-cash charge reduced taxable profit. If you can say that in one sentence, every follow-up becomes easy.
Can you handle a changed assumption?
Setting the tax rate to zero is the standard probe. If you can work it through calmly and explain why cash does not move, you have shown real understanding.
Do you close the loop?
Saying "and the balance sheet balances" takes two seconds and is expected. Leaving it out makes the answer feel unfinished.
Can you stay calm with numbers out loud?
This is also just a test of doing simple arithmetic while talking. Slow down and say each number as you go.
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 first.
Every number downstream depends on it. Say it before you start.
Forgetting the add-back on the cash flow statement.
The single most common error, and it breaks the balance sheet immediately.
Saying cash goes down.
The instinct is that a bigger expense means less cash. But the expense is non-cash and it saves tax, so cash rises.
Doing the balance sheet before the cash flow statement.
You need the cash figure first. Going out of order is how candidates end up stuck with an answer they cannot fix live.
Forgetting retained earnings.
Net income flows into equity. Candidates who only adjust the asset side get a $6 gap and freeze.
Rushing and making a sign error.
Slow down. Say each number as you go rather than racing to the end.
Not saying that it balances.
Two seconds, and it is what the interviewer is waiting to hear.
Ready to practice?
Answer this question out loud with an AI interviewer.