A company writes down a $100 liability. Which statement correctly describes the impact on the three financial statements?

• A. Pre-Tax Income increases by $100; Net Income increases by $60; Cash Flow from Operations decreases by $40; Liabilities decrease by $100; Shareholders' Equity increases by $60.
• B. Pre-Tax Income decreases by $100; Net Income decreases by $60; Liabilities increase by $100; Cash Flow from Operations unchanged.
• C. Pre-Tax Income increases by $100; Net Income decreases by $60; Cash Flow from Operations increases by $40; Liabilities decrease by $100; Shareholders' Equity increases by $60.
• D. Pre-Tax Income increases by $0; Net Income increases by $60; Cash Flow from Operations increases by $40.

Answer: (A)

When a company writes down a liability, it reduces the liability on the balance sheet and records a gain on the income statement for the amount of the write-down. Here, a 100 write-down creates a pretax gain of 100, so pretax income rises by 100. With a 40% tax rate, taxes increase by 40, leaving net income up by 60. The liability is reduced by 100, and that reduction flows through to shareholders’ equity as an increase in retained earnings equal to the net income increase, i.e., 60. Cash flow from operations, however, is affected only through non-cash adjustments: the gain is non-cash, so when reconciling net income to CFO you subtract the full 100 gain, which reduces CFO by 40 (since net income rose 60 after tax, subtracting 100 yields a net CFO impact of -40).