How Do the 3 Statements Link If Depreciation Goes Up $10?

Depreciation increases by $10, so pre-tax income falls by $10. At a 40% tax rate, taxes drop by $4 (a tax shield), so the after-tax hit to net income is $10 × (1 − 40%) = $6. Net income falls $6. This is the starting point for the whole walkthrough — always tax-affect the change on the income statement before moving on.

Start cash flow from operations with net income, which is down $6. But depreciation is a non-cash expense, so you add back the full $10. Net effect on cash flow from operations = −$6 + $10 = +$4. There's no change in investing or financing (the asset was already on the books; this is just a depreciation charge). So total cash rises by $4 — exactly the tax savings. This counterintuitive result (more depreciation → more cash) is the heart of the question.

Assets: cash is up $4, and PP&E is down $10 (the additional depreciation reduces the net book value of the asset, captured in accumulated depreciation). Net change to assets = +$4 − $10 = −$6. Liabilities & Equity: retained earnings falls by $6 (net income flows into retained earnings); no change to liabilities. Net change to L&E = −$6. Both sides fall by $6, so the balance sheet still balances. If your balance sheet doesn't balance, you almost always forgot the tax effect or the depreciation add-back.

Interviewers love to vary the tax rate — if it's 0%, net income falls the full $10, the add-back is $10, cash is unchanged, PP&E falls $10, retained earnings falls $10, and it balances. They may ask 'why does cash go up if you reported lower profit?' — because depreciation is non-cash and shields you from real cash taxes. A tougher variant: 'depreciation goes up $10 but it's a different driver' — the structure is identical, just tax-affect and add back. The same framework powers depreciation's three-statement impact and any non-cash-charge question (write-downs, amortization, SBC).