ACCOUNTING · WORKED EXAMPLE
How depreciation flows through the three statements
A $10 million expense does not mean $10 million leaves the bank account.
Start with the question
Depreciation increases by $10 million. Assume a 25% tax rate, a fully usable tax shield and no other changes. What happens to the three statements?
Work the income statement
Operating income falls by $10 million. Taxes fall by $2.5 million, so net income falls by $7.5 million. Depreciation is an expense even though it is not a current-period cash payment.
Reconcile cash flow
Start with the $7.5 million decline in net income, then add back the $10 million noncash expense. Cash from operations rises by $2.5 million. With no other changes, cash rises by $2.5 million.
Make the balance sheet balance
Cash rises by $2.5 million and net PP&E falls by $10 million. Total assets fall by $7.5 million. Retained earnings fall by $7.5 million through net income. Both sides balance.
Handle the follow-up
If the tax shield cannot be used now, the immediate cash benefit may disappear or be deferred. Do not promise the $2.5 million cash increase without the tax assumption. Buying the asset is a separate investing cash flow; this question isolates depreciation.
Say it aloud
“Net income falls by $7.5 million. I add back $10 million of depreciation, so cash rises by $2.5 million from the tax saving. Net PP&E falls by $10 million and retained earnings fall by $7.5 million, so the balance sheet balances.”
Written by Accretive Thinking. Fictional companies and illustrative assumptions. Educational material, not investment advice. Expert editorial review pending.