The largest source of cash inflows is profit making activities from sales of goods and services. For a business to succeed it must earn a profit.
But it can be treated differently.
The cash flow report shows a very important part of the story of a business but do not tell the whole story.
Although cash flows are the heartbeat of every business, the profit earned by the business for the period is shown by net income.
From accountant’s point of view it is possible to define precisely net income as the difference between revenues and expenses.
Logically, cash flows and net income must be the same, because these are simply cash increase equal the amount of income earned for the year.
Why do we need the same numbers in financial reports?
This is simply because the profit can’t be calculated from cash flows and two figures are completely different numbers.
First of all, there are assumptions underlying income measurement and their ethical application:
• The continuity assumption states that when measuring income it is assumed a business will continue to operate indefinitely
• The periodicity issue recognizes that the measurement of net income for a given period is at best an estimate
• The matching rule states that revenues and expenses are recorded in the accounting period, in which they are occurred.
The timing of cash receipts and payments is irrelevant.
These assumptions, especially the matching rules, explain why net income and cash flows show different results.
Assume, at the year-end a company has receivables from sales during the latter part of the year, i.e. the company sold products on credit.
These receivables will be collected next year and that is why cash collections during the year do not equal the amount of revenues for the year.
Furthermore, it is possible that some of the company’s costs are not paid by the year-end. Correct timing to record revenues and expenses is needed because cash inflows and outflows take place too late or too early for correctly measuring profit for a period.
Accrual accounting consists of all the techniques used to apply the matching rule and the correct timing of recording net income.
In contrast to Accrual accounting, the alternative is Cash basis accounting.
Under the cash basis of accounting revenues are recognized when cash is received and expenses are recognized when they are paid.
Cash basis accounting tracks cash flow, but it does a poor job of matching revenues earned with money laid out for expenses:
• Buy products in December for $100. At the year-end there is a loss of $100 with no revenue to offset it
• Sell the products in January for $200. The report for January shows $200 profit when in actuality there is revenue of $100 over the two months
While neither accounting methods are perfect, both have some negative and positive sides. Taking into account that cash basis accounting may be sufficient for some small businesses, accrual accounting is the standard accounting practice for most big companies.
Accrual accounting is applied in the following ways:
• Revenue recognition
• Expense recognition
• Adjusting the accounts
As it follows, revenue and expense recognition do not depend on the payment of cash and can be recorded even though cash has not been received.
By the way, many expenses are not directly identifiable, for example accounting costs and audit fees. These nondirect expenses are necessary as direct expenses but can’t be matched with particular sales. Therefore, they are just simply recorded in the period in which the benefit to business occurs.
Accrual accounting involves adjusting the accounts. This is explained in the article Deferrals and Accruals.