How Depreciation Affects the Three Statements

Start at the top. Depreciation increases by $10, so operating expenses rise $10 and pre-tax income (EBT) FALLS by $10. Apply the tax rate — assume 40% for the classic version of this question. Taxes fall by $10 × 40% = $4. Net income therefore falls by $10 − $4 = $6. Key insight: the company doesn't lose $10 of profit, it loses only $6, because the $10 deduction saved $4 in cash taxes. That $4 saving — the depreciation 'tax shield' — is the whole reason the answer to this question is interesting.

At the top of the cash flow statement, net income is now $6 LOWER. But depreciation is a non-cash expense — no cash actually left the building — so under the indirect method you ADD BACK the full $10 of depreciation. Net change to cash flow from operations = −$6 (lower net income) + $10 (depreciation add-back) = +$4. Nothing changes in investing or financing for this question. So total cash at the bottom RISES by $4. This is the counterintuitive punchline: an EXPENSE going up causes CASH to go up, because the only real cash effect was the $4 of tax savings.

Walk the balance sheet. ASSETS: cash is up $4 (from the cash flow statement), and PP&E is down $10 (accumulated depreciation increased). Net change to assets = +$4 − $10 = −$6. LIABILITIES & EQUITY: retained earnings falls by the $6 drop in net income (it flows through equity). Net change to L&E = −$6. Assets fall $6, equity falls $6 — the balance sheet BALANCES. Always close the loop by confirming this: interviewers want to hear you state that assets equal liabilities plus equity at the end, because proving the balance is the real test of whether you understand the linkages.