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The impact of a £10 depreciation on the Financial Statements

By Victor Paquet (Mergersight Operations) and Carlo Lepoardi & Tommaso Arona (Boston University partners)


 


Walkthrough


This is probably one of the most famous and important accounting questions an interviewer can ask you after walking them through the Income Statement, Balance Sheet and Cash Flow Statement.


Our advice to answer this question: start with the income statement before following up with the effects on the cash flow statement, to finalise with the impacts on the balance sheet as the 3 statements are all linked with each other.



Income Statement

The Operating Income declines by £10. You need to take into account taxes and assume, for instance, a corporate tax of 40%.

As such, Net Income increases by:

Change in operating income x (1– tc) = -£10*(1 - 40%) = -£6.


Cash Flow Statement

The Income and Cash Flow statements are linked to each other through the Net Income value you computed in the Income Statement, which is the first item of your Cash Flow Statement.


As such, Net Income decreases by £6 in the Cash Flow Statement. However, depreciation is a non-cash expense, and always needs to be added back in the Cash Flow Statement,.


Overall, Cash Flows from Operating Activities increase by +£10 - £6 = +£4


Considering there are no other changes in the Cash Flow Statement, your net change in cash at the bottom of the statement is +£4.



Balance Sheet

Asset side: following the added depreciation, Plants, Property & Equipment (PPE) goes down by £10.


Taking into account your change in net cash from the Cash Flow Statement, Cash is up by £4 in the Balance Sheet.


Overall, Change in PPE + Change in Cash = -£10 + £4 = -£6. Hence, your total assets are down by £6.


The golden rule in accounting is Assets = Equity + Liabilities, so you need to find a decrease in £6 in total equity and liabilities.


The Income Statement and Balance Sheet are also linked through Net Income, a line of equity in the Balance Sheet. Hence shareholders’ equity and liabilities are down by £6.




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