What are the effects on the three statements when a company writes down $100 of debt (a liability)?

What are the effects on the three statements when a company writes down $100 of debt (a liability)?

• A. Income Statement: Pre-Tax Income increases by $100; Net Income increases by $60. Cash Flow Statement: Net Income increases by $60, but the debt write-down is noncash, so CFO decreases by $40. Balance Sheet: Cash down $40; Debt down $100; Shareholders' Equity up $60.
• B. Income Statement: Pre-Tax Income decreases by $100; Net Income decreases by $60. Cash Flow Statement: CFO increases by $60. Balance Sheet: Cash up by $60; Debt up $100.
• C. Income Statement: Pre-Tax Income increases by $100; Net Income increases by $60. Cash Flow Statement: CFO increases by $100. Balance Sheet: Cash up $100; Debt down $100.
• D. Income Statement: Pre-Tax Income unchanged. Cash Flow Statement: CFO unchanged. Balance Sheet: No changes.

Answer: (A)

When a company writes down a debt by 100, it is effectively extinguishing part of a liability, which creates a gain on the income statement of 100 before tax. With a 40% tax rate, taxes rise by 40, so net income increases by 60. The noncash nature of this gain means it must be subtracted in the cash flow from operations reconciliation, so cash flow from operations falls by 40 (net effect: NI up 60, but a 100 noncash gain is subtracted). On the balance sheet, the liability decreases by 100, cash decreases by 40 due to the tax payment, and equity increases by 60 because retained earnings rise with the higher net income. This aligns with the described outcome: pre-tax income up 100, net income up 60; cash flow from operations down 40; and the balance sheet showing cash down 40, debt down 100, and shareholders’ equity up 60.

When a company writes down a debt by 100, it is effectively extinguishing part of a liability, which creates a gain on the income statement of 100 before tax. With a 40% tax rate, taxes rise by 40, so net income increases by 60. The noncash nature of this gain means it must be subtracted in the cash flow from operations reconciliation, so cash flow from operations falls by 40 (net effect: NI up 60, but a 100 noncash gain is subtracted). On the balance sheet, the liability decreases by 100, cash decreases by 40 due to the tax payment, and equity increases by 60 because retained earnings rise with the higher net income. This aligns with the described outcome: pre-tax income up 100, net income up 60; cash flow from operations down 40; and the balance sheet showing cash down 40, debt down 100, and shareholders’ equity up 60.