If you’re like most managers or business owners, you are exposed to financial information on a regular basis, particularly the basic financial statements: the Balance Sheet, the Income Statement, and the Statement of Cash Flows.  Part of your job as an owner or manager is to read and interpret these financial statements in order to draw conclusions about performance, financial position, and future prospects.

Those who are not formally trained in finance and accounting often draw conclusions based on certain commonly-occurring misconceptions about information contained in financial statements.  In my experience, the primary misconception about financial statements, specifically, the Income Statement, is rooted in the belief that profits = cash.

This is probably the most common of the financial statement myths.  Are profits a good thing?  Of course.  Are profits equal to cash flows?  The short answer is no, or more precisely, eventually, but not today.

Confused?  Rightfully so, and here’s why.  Revenues and expenses reported in an entity’s income statement do not necessarily represent cash transactions.  Generally Accepted Accounting Principles (affectionately referred to as “GAAP” by the accountants that dream these things up) require that financial statements be prepared using the accrual basis of accounting.

Third-party users of financial statements (banks, investors, government regulators, to name a few) generally require that an entity’s financial statements be prepared  in accordance with GAAP, using the accrual basis of accounting. The accrual basis of accounting, as opposed to the cash basis of accounting, is the preferred method of financial reporting because it more accurately reflects the “true” economic profit or loss during a given period.  Even if an organization is not required to provide financial statements to third parties, the accrual basis is significantly more useful, and thus recommended, for internal use by managers and owners.

Accrual basis financial statements are far more preferable to cash basis financial statements because they employ one of the longest-standing, inviolate tenets of financial accounting and reporting – the matching principle.  The matching principle provides that, during any given period, revenues earned must be matched to the expenses incurred to generate those revenues.  You’ll notice that this definition specifically refers to (a) revenues earned, vs. cash received and (2) expenses incurred vs. cash paid.  In essence, under the accrual basis of accounting, revenues and expenses, and thus profit or loss, are reported when transactions occur, rather than when cash is exchanged.  A simple example illustrates the point.

Assume that ABC Company, a consulting firm, provides marketing services.  ABC entered into a contract with a client to provide services over the course July.  The total contract price was $20,000, of which $5,000 was paid in advance, with the $15,000 balance due  30 days after the services were rendered.  ABC received the $5,000 deposit, performed the services during the month, and billed the client the balance of $15,000 on July 31st.  The employee who performed the services for ABC on this project earned $12,000, which was paid during the month.  For simplicity, assume these were the only transactions during July.

Under the accrual basis of accounting, because revenues are recorded when earned, ABC ‘s revenues were $20,000 for the month and its expenses were $12,000, resulting in a profit of $8,000.  Despite the fact that profits for the month were $8,000, ABC’s cash actually decreased by $7,000 ($5,000 cash deposit less $12,000 in salaries).  The reason for this difference is due to the fact that ABC billed the client $15,000 at the end of the month, which was scheduled to be collected within 30 days.  Therefore,  as of July 31st, ABC had $15,000 of accounts receivable outstanding.  This amount was properly reported as revenue.

If ABC had used the cash basis to account for the same transactions, its income statement would have been distorted and thus, significantly less useful.  Using the cash basis, ABC would have reported a $7,000 loss for the month ($5,000 in cash received less $12,000 in salaries).  Under this reporting scenario, neither ABC, nor the external users of its financial statements, would be able to accurately gauge its financial performance during the month, because the income statement would not reflect the true economic substance of the contract – revenues reported (in this case, $5,000) would not be properly matched with the expenses incurred to produce those revenues.  Stated differently, the $12,000 of employee salaries incurred would have produced more than $5,000 in revenue.  The income statement would also be distorted during the subsequent month, when the balance of the contract, $15,000, would be reported as revenue (when the cash is received) with no corresponding expenses (salaries were paid and reported during the previous month).  This problem becomes compounded proportionately as the number of transactions during any given period increases.

Yes, the $15,000 in our example will eventually be received and converted to cash.  However, in order to enhance the usefulness of the income statement, it is vitally important that it reflect the economic substance of transactions occurring during any given period, as opposed to  cash receipts or disbursements.  For that reason, profits will never equal cash.  Fortunately, the accountants, always one step ahead, figured out another way to provide information about cash inflows and outflows – the Statement of Cash Flows, a topic for another day.

Tagged as: accounting, accrual basis, Cash Flows, Financial Statements, income statement, profit vs. cash