A non-cash expense can reduce profit while increasing cash through a tax saving. The balance-sheet check catches the missing link.
Know what each statement tells you
The income statement describes performance over a period. The balance sheet is a snapshot of assets, liabilities and equity at a date. The cash flow statement explains how cash changed, separating operating, investing and financing activities.
The SEC’s introductory guide also discusses the statement of shareholders’ equity. Interview shorthand about ‘the three statements’ is not a claim that company reporting contains only three documents.
An original worked example
Assume depreciation rises by $12, the tax rate is 25%, the depreciation is immediately tax-deductible, the company can use the tax saving, and nothing else changes. These assumptions remove deferred-tax complications so you can focus on the links.
On the income statement, pre-tax income falls by $12 and tax expense falls by $3. Net income therefore falls by $9. Under the indirect cash flow method, start with that $9 reduction and add back the extra $12 of depreciation. Operating cash flow and closing cash rise by $3.
| Statement | Movement | Change |
|---|---|---|
| Income statement | Net income | −$9 |
| Cash flow statement | Non-cash depreciation add-back | +$12 |
| Cash flow statement | Net change in cash | +$3 |
| Balance sheet | Cash / net PP&E | +$3 / −$12 |
| Balance sheet | Retained earnings | −$9 |
Check the balance sheet out loud
Cash rises by $3, while net property, plant and equipment falls by $12 because accumulated depreciation rises. Total assets are down $9. Retained earnings fall by the $9 reduction in net income, assuming no change in distributions. Liabilities are unchanged, so both sides fall by $9.
Do not finish at ‘cash is up’. The final balance check demonstrates that you followed the entire effect rather than memorising one statement.
Change the premise and see what breaks
Now assume the depreciation does not reduce current cash taxes. You cannot retain the $3 immediate cash benefit without revisiting the tax treatment. The correct answer depends on whether you are dealing with a temporary difference, a permanent difference or a simplified no-tax setting.
Another useful variation is a purchase of inventory with cash. At the time of purchase, cash falls and inventory rises; there is no immediate cost of goods sold simply because you bought the inventory. The expense arrives when the inventory is sold, subject to the relevant accounting treatment.
Use a three-line error log
For each missed question, write the event, the link you missed and a fresh test. For example: ‘Depreciation rises; forgot the tax saving; repeat with $20 and a 30% tax rate.’ The fresh numbers force you to rebuild the logic.
In Callback, the explanation and interviewer note sit alongside practice so you can connect the result to what the question is testing. Revisit the question after a gap and try the full walkthrough without looking.
Further reading
Primary references for the underlying concepts. Worked examples and preparation exercises in this guide are original to Callback.
SEC — Beginners’ Guide to Financial StatementsNow make it
second nature.
Turn the concept into practice with Callback for iPhone and iPad.
