Walk me through how a $10 increase in depreciation flows through the three statements (40% tax).
Model answer
Income statement: pretax income falls $10, so net income falls $6. Cash flow statement: start with net income -$6, add back the $10 non-cash depreciation, so cash rises $4. Balance sheet: cash up $4, PP&E down $10 (net assets -$6); on the other side retained earnings down $6. It balances. Net effect: you saved $4 in cash via the tax shield.
⚠ Common wrong answer: "Net income falls by $10, and cash falls too because the expense went up." Why it fails: It forgets the tax shield and the non-cash nature of depreciation: net income falls only $6 at a 40% tax rate, and cash actually RISES $4 because no cash left the business while the tax bill shrank.
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More from Accounting & the 3 Statements
- What are the three financial statements and what does each show?
- How are the three statements linked?
- A company buys $100 of inventory on credit (no cash yet). Walk through the three statements.
- Why can a profitable company still run out of cash?
- What's the difference between cash-based and accrual accounting?
- If you could use only one statement to evaluate a company, which would you pick and why?
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