If a company records $10 depreciation expense and faces a 40% tax rate, which of the following describes the effects on the Income Statement, Cash Flow from Operations, and Balance Sheet?

If a company records $10 depreciation expense and faces a 40% tax rate, which of the following describes the effects on the Income Statement, Cash Flow from Operations, and Balance Sheet?

• A. Income Statement: net income decreases by 6; Cash Flow from Operations increases by 4; Cash on the balance sheet increases by 4; PPE decreases by 10.
• B. Income Statement: net income decreases by 6; CFO decreases by 4; Cash increases by 10; PPE decreases by 10.
• C. Income Statement: net income increases by 6; CFO increases by 14; Cash increases by 14; PPE decreases by 10.
• D. Income Statement: net income decreases by 10; CFO increases by 0; Cash increases by 0; PPE decreases by 10.

Answer: (A)

Depreciation is a non-cash expense, but it lowers taxable income and therefore creates a tax shield. With 10 of depreciation and a 40% tax rate, taxes saved = 0.40 × 10 = 4. This makes net income drop by 10 (the expense on the income statement) minus 4 (the tax saving), so net income decreases by 6. In the cash flow from operations, you start with net income and add back non-cash charges like depreciation. So CFO changes by -6 + 10 = +4. The business effectively increases cash by 4 from the tax shield and the timing difference. On the balance sheet, depreciation reduces PPE by 10 (accumulated depreciation reduces gross PPE). Cash increases by 4 from the CFO effect. Net equity would decline by 6 due to the lower retained earnings, keeping the accounting equation in balance. The result described is net income down by 6, CFO up by 4, cash up by 4, and PPE down by 10.

Depreciation is a non-cash expense, but it lowers taxable income and therefore creates a tax shield. With 10 of depreciation and a 40% tax rate, taxes saved = 0.40 × 10 = 4. This makes net income drop by 10 (the expense on the income statement) minus 4 (the tax saving), so net income decreases by 6.

In the cash flow from operations, you start with net income and add back non-cash charges like depreciation. So CFO changes by -6 + 10 = +4. The business effectively increases cash by 4 from the tax shield and the timing difference.

On the balance sheet, depreciation reduces PPE by 10 (accumulated depreciation reduces gross PPE). Cash increases by 4 from the CFO effect. Net equity would decline by 6 due to the lower retained earnings, keeping the accounting equation in balance. The result described is net income down by 6, CFO up by 4, cash up by 4, and PPE down by 10.