Why the Cash for the Business Does Not Equal to the Profit
The purpose of this essay is to demonstrate the understanding of the accounting double entry system and how these transactions appear on an income statement and a balance sheet as well as to interpret reasons why the cash position for the business does not equal to the profit for the period. By showing the spreadsheet, two financial statements and looking into theories of matching principle, prepayments and accruals, provisions(bad debts and depreciation), it is not hard to distinguish the cash flow from the profit.
Content It is vital to understand the cash position and the profit do not necessarily go together when running business. Profitable businesses still can go out of business because of cash flow problems. Cash flow is the movement of money in and out of the company’s bank account during a financial period. While profits are determined by the income earned with the expenses incurred in earning that income, which reveals the profit is simply the result of income minus expenses.
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However, transactions of income and expenses take place not only on a cash basis but also on a credit basis. Accounting, therefore, has to be used to adjust the timing difference in recording transactions to reflect the whole genuine picture. An important principle that is particularly relevant to the interpretation of the distinction between the cash position and the profit is the matching principle.
The matching principle, also called accruals principle, recognizes income when it is earned and recognizes expenses when they are incurred, not necessarily when money is received or paid out (a method called cash accounting), which allows better calculation and evaluation of actual profits and performance, and reduces discrepancy from timing mismatch between when costs are incurred and when revenue is realized. In the spreadsheet, the transaction of “company sells goods on credit for $7,000” illustrates the income, with the corresponding effect to the profit, by matching principle well.
That means the double entry is an increase in asset receivables and an increase in income when the income is earned rather than it is received. This income is accrued by treating as income for profit purposes even though no cash payment has yet been made by the customer. Likewise, the transaction of “Company carries out advertising. The cost of $1,000 will be paid next month” revealed matching principle as well in interpreting expenses. The expense is accrued when advertising occurs for profit purpose though the money has not been paid yet.
From which, we can initially acknowledge the gap between the cash position with profits. Prepayments also play a pivotal role in leading the difference between the cash and profits, because prepayments, such as insurance, require cash payments made in advance and are not recognized as expenses, but as assets, until the actual products are sold. For instance, the company needs to pay insurance 12 months in advance for $60,000 in cash on 1 March.
At the end of financial year on 30 June, the business will only treat the amount of $20,000 (insurance premium for 4 months) which has occurred as an expense and will treat the remaining amount of $40,000 as a prepayment in a current asset account, even though $60,000 cash has been paid in advance. So the amount of cash outflow equals to the expense paid at year end plus the remaining prepayment which has not been paid. But due to the timing difference, the influence on the profit is later than that on the cash.
Accruals, such as electricity bill, on the contrary, accrue expenses rather than cash in advance according to the historical data even if the bill has not been received and cash has not been paid yet for profit purpose. Consequently, profits have been affected while the cash flow does not change until the bill received and paid. Then, provision is a liability against the balance of the cash flow and profits as well. Provisions are estimates of possible liabilities that may arise shown in the balance sheet, but where there is uncertainty as to timing or the amount of money.
The estimate is based on the likely cost to be incurred in the future rather than the present. One typical type of provisions is bad debts that does not affect cash, but decreases the current asset receivables and increases the expense with a corresponding decline in profit. As the company foresees that the customer experiences the difficulty in paying back the money, the provision account has to set aside certain amount of money to account for the bad debts that is likely to be incurred, which brings the negative impact on profits and no impact on cash ultimately.
A further example against the reconciliation between the cash flow and the profit is depreciation, which is also one important type of provisions. In accrual accounting, depreciation (or amortization) is an expense where no cash is outlaid but the expense is shown with a corresponding decrease in profit. Depreciation, which is used to distribute the cost of assets to write off the value of each fixed asset over its expected life span, comprises the usage for tangible assets such as buildings, equipments, and infrastructures (not the land) as well as for intangible assets, such as goodwill and patents, etc.
For example, if a machine is bought for $100,000 with a life span of 10 years, then the depreciation cost of $10,000 of the machine is spread to each year, rather than charging $100,000 in the first year and nothing in the next 9 years. Therefore, the corresponding profit will be persistently diminished in 10 years until assets can be depreciated in a nil value in the balance sheet. But during this period, there is no cash impacted by the depreciation at all.
That is the reason why in reporting profits, some companies show the profit before depreciation(or amortization) is deducted because it can be a substantial cost, but one that does not result in any cash flow. Conclusion In summary, given the number of factors that mentioned above, including matching principle (accrual accounting), prepayments and accruals, provisions(bad debts and depreciation), we can conclude that the cash flow and profits – two very important aspects of any business – do not reconcile necessarily. But they are two areas over which the business does have control in managing and implementation to achieve optimum results.