Why the Cash for the Business Does Not Equal to the Profit
Executive Summary
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. 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,
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. 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,