In this article
Before you start
This page belongs to the investment banking interview questions guide, and it pairs with the three-statement walkthrough questions, which practise the same skill on other changes.
Why interviewers ask this
A depreciation walk-through is a fast test of whether a candidate understands how accounting fits together, not just whether they can recite definitions. Candidates report that questions of this kind, usually a small change such as 10 units of depreciation, come up in investment banking technical rounds.
A weak answer lists the statements and guesses at the direction of each line. It often says cash falls because an expense was booked. A strong answer picks a tax rate out loud, moves one number at a time through the income statement, the cash flow statement and then the balance sheet, and ends by checking that assets still equal liabilities plus equity.
Accounting technicals for IB from first principles
- Accounting technical
- An accounting technical is an interview question that asks you to trace an accounting event, such as a depreciation charge or an inventory purchase, through the income statement, cash flow statement and balance sheet and say which lines move, in which direction and by how much.
- Indirect method
- The indirect method is a way of presenting cash flow from operating activities that starts from net income and adjusts it for non-cash items and changes in working capital until it reaches the cash actually generated by operations.
In plain words
Think of a household. The balance sheet is a photograph of what the family owns and owes today. The income statement is a diary of what the family earned and spent this year. The cash flow statement counts only the money that actually moved through the bank account. A car that loses value this year makes the family worth less on paper, but no money leaves the account.
The analogy breaks in one place. A household's tax bill rarely depends on the paper loss in its car, but a company's tax bill does depend on depreciation, and that link is the whole technical.
In one precise sentence, an accounting technical asks you to apply the rule that every change must keep assets equal to liabilities plus equity while linking profit to cash.
How the three statements link
The three statements link at three points, and every technical walks along them. First, net income from the income statement is the first line of operating cash flow on the cash flow statement. Second, the same net income, less any dividends paid, is added to retained earnings, the profit the company has kept, in equity on the balance sheet. Third, the ending cash from the cash flow statement is the cash line on the balance sheet.
For example, a depreciation charge lowers net income, so it reaches the cash flow statement through the first link, retained earnings through the second, and the cash line through the third. Every technical follows from these links. When you answer, say which links the event uses.
Step 1: The three statements measure different things
The balance sheet shows what a company owns and owes at a fixed point in time, while the income statement and the cash flow statement cover a period, according to the U.S. Securities and Exchange Commission (SEC) beginners' guide. The balance sheet balances because assets equal liabilities plus equity. Under the International Financial Reporting Standards (IFRS) Conceptual Framework, equity is "the residual interest in the assets of the entity after deducting all its liabilities." Balance-sheet equity is book value, not market value.
The same SEC guide says there are four main financial statements, adding the statement of shareholders' equity, so "the three statements" is an interview convention rather than a complete list. The SEC also notes that an income statement can tell you whether a company made a profit, while the cash flow statement tells you whether it generated cash. That gap between profit and cash is what the technical exploits.
You now know what each statement answers; the next step moves one number.
Text description of the diagram
- The balance sheet shows what a company owns and owes at a fixed point in time.
- The income statement and the cash flow statement cover a period.
Step 2: The income statement shows depreciation lowers net income by less than the charge
Depreciation is an expense that spreads the cost of a long-lived asset over its useful life, so it reduces profit without any cash leaving the business. Take a depreciation charge of 10 and a 40% tax rate, both illustrative: pretax income falls by 10 and the tax bill falls by 4.1 Depreciation of 10 at a 40% tax rate lowers net income by 6.1
Input: an expense of 10 and an assumed tax rate. Output: net income down by 6. The tax rate is your assumption, so state it aloud; the answer changes with it, as the worked example shows. You now know the income statement effect; the cash flow statement is next, and it is where the common error appears.
Step 3: The cash flow statement adds depreciation back and cash rises
The cash flow statement adds depreciation back to net income because no cash left the business. It is arranged in operating, investing and financing sections: International Accounting Standard (IAS) 7 defines investing activities as the acquisition and disposal of long-term assets and financing activities as changes in contributed equity and borrowings.
Operating cash flow is built with the indirect method, which starts from net income (U.S. Generally Accepted Accounting Principles (GAAP)) or profit or loss (IAS 7) and adjusts for non-cash items, as the guidance from BDO (the accounting network) on Accounting Standards Codification (ASC) 230 explains. It does not start from earnings before interest, taxes, depreciation and amortization (EBITDA).
In the example, cash from operations rises by 4 because the 10 is added back to a net income that fell by 6 (illustrative).1 In the standard interview version, where book and tax depreciation are equal, cash rises only through the tax shield, 10 times 40%.1
Step 4: The balance sheet closes when assets and retained earnings both fall
The balance sheet closes because every change to assets is matched by a change to liabilities or equity. Net property, plant and equipment falls by 10, as the asset is written down, and cash rises by 4 (illustrative).1 Assets fall by 6 and retained earnings fall by 6, so the balance sheet still balances.1
Retained earnings is the part of equity made of profit the company has kept, and the 6 of lost net income flows into it. Liabilities are untouched. A present obligation to transfer an economic resource is how the IFRS Conceptual Framework defines a liability, and no obligation changed here.
Input: the income statement and cash flow results. Output: a balance sheet that foots. End your spoken answer with this check; it shows you can verify your own work.
Step-by-step description
- The balance sheet always balances.
- Net income falls by 6.
- Cash from operations rises by 4.
- Assets and equity both fall by 6.
- The balance sheet balances because assets equal liabilities plus equity.
- Depreciation of 10 at a 40% tax rate lowers net income by 6.
- Cash from operations rises by 4 because the 10 is added back to a net income that fell by 6.
- Assets fall by 6 and retained earnings fall by 6, so the balance sheet still balances.
Knowing it is half the job. Saying it is the other half.
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Start Free Trial →Worked example
A depreciation charge of 10 was run at three illustrative tax rates in a short script, with every line computed rather than guessed.1 The table shows the change in each line relative to before the charge.
| Line (change, illustrative $) | 0% tax | 25% tax | 40% tax |
|---|---|---|---|
| Pretax income | -10 | -10 | -10 |
| Net income | -10 | -7.5 | -6 |
| Cash from operations | 0 | 2.5 | 4 |
| Net property, plant and equipment | -10 | -10 | -10 |
| Cash | 0 | 2.5 | 4 |
| Total assets | -10 | -7.5 | -6 |
| Retained earnings | -10 | -7.5 | -6 |
At a 0% tax rate net income falls by 10 and cash does not change, which is why depreciation alone never creates cash.1 The tax shield is the difference: 2.5 at 25% and 4 at 40%.1
Text description of the diagram
- At a 0% tax rate net income falls by 10 and cash does not change.
- The tax shield is 2.5 at 25% and 4 at 40%.
A second, quick case in the same script: buying inventory worth 10 with cash raises inventory by 10 and lowers cash by 10, so total assets are unchanged and the income statement does not move (illustrative).1 Nothing is expensed until the inventory is sold, which is why this variation is often paired with depreciation.
Five more common technicals, each at an assumed 40% tax rate (illustrative), with tax paid in cash in the same period:1
| Event | Net income | Cash | Balance sheet effect |
|---|---|---|---|
| Raise 100 of debt | 0 | +100 | cash +100, debt +100 |
| Buy 100 of property, plant and equipment with cash | 0 | -100 | property, plant and equipment +100, cash -100 |
| Write inventory down by 10 | -6 | +4 | inventory -10, cash +4, retained earnings -6 |
| Credit sale of 10 (receivables up 10) | +6 | -4 | receivables +10, cash -4, retained earnings +6 |
| Pay 10 of interest | -6 | -6 | cash -6, retained earnings -6 |
Trade-offs and edge cases
The textbook answer changes in a few situations, and interviewers often probe them.
The tax rate is an assumption. The result, net income down 6 and cash up 4, holds only for the rate you state. Say "I will assume a 40% tax rate" and be ready to redo the arithmetic at another rate.
Working capital moves cash too. Working capital is the short-term operating assets and liabilities, such as receivables, inventory and payables, that tie up or release cash. An increase in receivables or inventory uses cash, so it is subtracted from net income in the indirect method; an increase in payables keeps cash in the business, so it is added. The logic is that profit counted a sale or cost that cash has not yet matched.
Direct versus indirect presentation. Both methods reach the same operating cash flow, and the indirect method is the one most entities use.
| Dimension | Indirect method | Direct method |
|---|---|---|
| Starting point | Net income, adjusted | Major classes of cash receipts and payments |
| Operating cash flow | Same result | Same result |
| Use in practice | Most entities | Encouraged, not required |
Book and tax depreciation differ. Real companies often use faster depreciation for tax than for the books. Cash taxes then fall by more than the book tax expense, and the gap is recorded as a deferred tax liability on the balance sheet, under IAS 12 Income Taxes and ASC 740.
Non-cash transactions. Investing and financing transactions that need no cash are excluded from the cash flow statement but disclosed separately, per IAS 7 paragraph 43. A gain on the sale of an asset is subtracted from operating cash flow, because the cash proceeds belong in investing.
The financial modeling interview questions show how these links carry into a full model, and the discounted cash flow walkthrough uses the same logic when it turns profit into free cash.
How to answer it in an interview
Walk me through how ten dollars of depreciation affects the three statements.
I will assume a forty percent tax rate. Depreciation lowers pretax income by ten, taxes fall by four, so net income falls by six. On the cash flow statement I start from net income, add back the ten because no cash left the business, so cash from operations rises by four. On the balance sheet, net property, plant and equipment falls by ten and cash rises by four, so assets fall by six, matching retained earnings down six. It balances. In the standard version, where book and tax depreciation match, cash goes up only because of the tax shield.
The spoken structure: state the tax rate, go income statement, then cash flow statement, then balance sheet, and finish with the balance check. The 100 investment banking technical questions give more prompts to rehearse this out loud.
Common mistakes
- "Depreciation reduces cash." (wrong) It is a non-cash charge. (right) "Depreciation is added back, and cash rises by the tax shield."
- "Profit equals cash." (wrong) The SEC separates the two statements for a reason. (right) "The income statement shows profit; the cash flow statement shows whether cash was generated."
- "There are only three statements." (wrong) The SEC lists four. (right) "The three core statements, plus the statement of shareholders' equity."
- "Net income falls by ten." (wrong) That ignores the tax rate, and the answer depends on the assumption. (right) "At 40% it is six; at zero it is ten."
Follow-up questions
Why does depreciation not reduce cash?
Depreciation spreads the cost of an asset already bought, so no payment happens in the period of the charge. The cash left when the asset was acquired, which sits in investing activities.
What if the tax rate is zero?
Net income falls by the full 10, the add-back is 10, and cash does not change. Net property, plant and equipment and retained earnings both fall by 10, so the balance sheet still balances.1
What happens if the company raises 100 of debt?
Cash rises by 100 and debt rises by 100, so assets and liabilities both go up by 100 and equity is unchanged. There is no income statement effect until interest is charged.1
Does the cash flow statement start from EBITDA?
No. The indirect method starts from net income under U.S. GAAP or from profit or loss under IAS 7, then adjusts for non-cash items and working capital.
What is the difference between the direct and the indirect method?
The direct method lists cash receipts and payments by class, and the indirect method adjusts net income. Both give the same operating cash flow, per the BDO guidance above. The corporate finance interview questions and the mergers and acquisitions questions apply these statements to valuation and deals.
- Accounting technicals trace one change through all three statements and check the balance.
- Depreciation lowers net income by the charge times one minus the tax rate, but changes no cash directly.
- In the standard version, cash rises only through the tax shield, the charge times the tax rate.
- The indirect method starts from net income and adds back non-cash items.
- State your tax rate aloud and finish with the balance check.
Sources
- Beginners' Guide to Financial Statements — U.S. Securities and Exchange Commission, 26 Oct 2026
- IAS 7 Statement of Cash Flows — IFRS Foundation, 26 Oct 2026
- Conceptual Framework for Financial Reporting (2021 issued edition) — IFRS Foundation, 1 Jan 2021
- Statement of Cash Flows Under ASC 230 (Blueprint) — BDO, 1 Dec 2025
- IAS 12 Income Taxes — IFRS Foundation, 26 Oct 2026
