If depreciation expense is $10 pre-tax, what is the effect on the three financial statements?

• A. IS: EBIT declines by $10; NI declines by $8; CFS: CFO increases by $2; BS: Cash increases by $2; RE decreases by $8; PPE decreases by $10.
• B. IS: EBIT increases by $10; NI increases by $8; CFS: CFO decreases by $2; BS: Cash decreases by $2; RE increases by $8; PPE increases by $10.
• C. IS: EBIT unchanged; NI unchanged; CFS: CFO unchanged; BS: Cash unchanged.
• D. IS: EBIT decreases by $10; NI decreases by $2; CFS: CFO increases by $12; BS: Cash increases by $12.

Answer: (A)

Depreciation is a non-cash operating expense that reduces accounting profit but does not directly reduce cash. Here, depreciation of 10 lowers EBIT by 10 because it’s part of operating expenses. The tax effect means net income falls by 10 minus the tax saved: with a 20% tax rate, taxes drop by 2, so net income declines by 8.

On the cash flow statement, you start with net income and add back depreciation since it didn’t use cash. So CFO changes by -8 + 10 = +2, meaning cash from operations rises by 2.

On the balance sheet, cash increases by 2 from the CFO boost; net PP&E decreases by 10 due to depreciation (accumulated depreciation lowers the asset’s book value); retained earnings decrease by 8 to reflect the lower net income. The accounting balance wires through consistently: assets fall by 8 overall, offset by the drop in equity (retained earnings) by 8.

This matches the described impacts: EBIT down 10, net income down 8, CFO up 2, cash up 2, RE down 8, and PP&E net down 10.