Depreciation Goes Up by $10: The Full Answer and Four Follow-Ups

At a 25% tax rate: operating income falls by $10 and net income by $7.50. On the cash flow statement net income is down $7.50, the $10 is added back because no cash left the company, and cash rises by $2.50. On the balance sheet cash is up $2.50 and net PP&E is down $10, so assets fall by $7.50, matched by a $7.50 fall in retained earnings. The general rule: net income falls by the charge times one minus the tax rate, and cash rises by the charge times the tax rate.

Most candidates who reach a first round can recite that. The interviewer knows it too, so the question is an opening move. The four follow-ups below decide the marks.

The answer, in order

Take the statements in the order the numbers flow: income statement, cash flow statement, balance sheet, and name that order before you start. Walk Me Through the Three Financial Statements explains why the order matters; Knowing the Answer Is Not the Same as Passing contrasts this walk recited with this walk understood. The understood version, said aloud:

"Depreciation is up $10, so operating income is down $10. At a 25% tax rate the tax bill falls by $2.50, so net income is down $7.50."

"On the cash flow statement I start from net income, down $7.50. Depreciation is a non-cash charge, so I add the $10 back. Cash from operations is up $2.50, nothing changes in investing or financing, and cash is up $2.50 for the period."

"On the balance sheet, cash is up $2.50 and net PP&E is down $10, because accumulated depreciation rose by $10. Total assets are down $7.50, and retained earnings are down $7.50 through the lower net income. Both sides fall by $7.50, so it balances."

Three short paragraphs, each handing a number to the next, then stop. The interviewer is grading the path you take.

Why cash rises when profit falls

The cash goes up for one reason: tax. Depreciation is an accounting charge for the wearing out of an asset the company paid for earlier. The IRS, in Publication 946, calls it "an annual income tax deduction that allows you to recover the cost or other basis of certain property". A bigger deduction means a smaller taxable profit and a smaller cheque to the tax authority, and that saved tax is the only cash that moves. The SEC's Beginners' Guide to Financial Statements puts the same step from the cash flow side: adjust net income for non-cash items, such as adding back depreciation.

On assessment calls I ask this question as it is written above, with no tax rate. Two answers come back again and again. The first has the right words and the wrong wiring: "depreciation goes up, that hits the income statement, and then cash flow goes down, I think, because it's an expense." The second is a clean recital that collapses on the follow-up: "why do we add depreciation back?" gets "because it's non-cash", and then nothing. Neither candidate could say where the $2.50 came from.

The $10 is a toy number. In a capital-heavy business the add-back is the size of the profit itself.

What the tax rate does to the answer

Interviewers pick a round rate for the arithmetic; question banks use 20%, 25%, 30% or 40%. The actual US federal rate is a flat 21%: the IRS instructions for Form 1120 say multiply taxable income by 21%.

Illustrative: a $10 rise in depreciation at each rate; the 21% row is the US federal statutory rate from the IRS instructions above.

The four follow-ups

"What if the company pays no tax?"

The 0% row above is the answer: no shield. Net income falls by the full $10, the company saves no tax, cash is flat, and assets and equity each fall by $10.

"Does EBITDA change?"

No. EBITDA sits above depreciation on the income statement, so it is unchanged, and EBIT falls by $10. The interviewer asks it to check you have placed the line. EBIT vs EBITDA vs Net Income places all three.

"Now include buying the asset"

A harder version gives you an asset price and a schedule instead of a depreciation figure: $100 of equipment, five-year straight line, 40% tax. Ask whether the purchase is in scope before you start. At purchase nothing touches the income statement: $100 of capital expenditure sits under investing, cash falls by $100 and PP&E rises by $100, so the balance sheet moves within assets. Then each year $20 of depreciation runs through as the $10 did: net income down $12, cash up $8, net PP&E down $20, retained earnings down $12.

"Why does the company have a deferred tax liability?"

Because tax depreciation and book depreciation are different numbers. For its accounts a company spreads an asset's cost over the years it is used. For its tax return the IRS requires MACRS, the Modified Accelerated Cost Recovery System, for most property placed in service since 1987, and the deductions arrive sooner than the book charge. More deduction now means less tax now, and a liability for the tax that comes due later, when book depreciation catches up.

The $10 walk assumes the two are the same. Say so at the balance sheet, and the interviewer knows you have seen the gap.

How to practise it this week

1. Walk it at three rates. 0%, 21% and 40%, aloud, without notes. The numbers change; the sentences should not.
2. Change the item. Swap depreciation for a $10 inventory write-down, then for a $10 rise in accounts receivable. The write-down behaves like depreciation; the receivable is revenue booked and not collected, so profit rises while cash falls.
3. Find both depreciation numbers in a real 10-K. The add-back on the cash flow statement and the deferred tax liability in the income taxes note, for a company you follow.

More free material on the technical interview is in the Knowledge Base, and new pieces land in IBB Insights.