Continuing with the last question, on Jan. 1 of Year 3 the equipment breaks and is deemed worthless. The bank calls in the loan. What happens in Year 3?

Now the company must writedown the value of the equipment down to $0.  At the beginning of Year 3, the equipment is on the books at $80 after one year’s depreciation.  Further, the company must pay back the entire loan.  Income statement: The $80 writedown causes net income to decline $48.  There is no further depreciation expense and no interest expense.   Cash Flow Statement: Net income down $48 but the writedown is non-cash so add $80.  Cash flow from financing decreases $100 when we pay back the loan.  Net cash is down $68.  Balance Sheet:  Cash (asset) down $68, PP&E (asset) down $80, Debt (liability) down $100 and Retained Earnings (shareholders’ equity) down $48.  Left side of the balance sheet is down $148 and right side is down $148 and we’re good!