The Difference between Cash and Profit
The accrual accounting method records revenue when it’s earned, regardless of whether money changes hands. You also record expenses when you incur them, regardless of whether they’re paid. The cash method of accounting uses the criteria of cash changing hands to determine when revenue and expense transactions are recorded. The cash method is simply posting revenue and expenses by using your checkbook checks, debits, and deposits.
Recognizing accounting transactions doesn’t hinge on cash being exchanged. As a result, you can expect to see a difference between a company’s cash balances and profit shown on the income statement. Not all costs are immediately expenses, and until a cost is an expense, it doesn’t appear on the income statement.
In the same way, not all cash receipts are immediately revenue. If a customer pays you in advance, you don’t recognize revenue until you provide the product or service to the client.
Seeing how noncash transactions affect profit
The statement of cash flows homes in on the difference between two amounts:
Ending balance in cash for the period
Net income for the period
Differences exist because net income factors in revenue earned but not yet collected from customers and expenses incurred but not yet paid — rather than reflecting only transactions involving cash. In other words, net income is computed by using the accrual method of accounting. The accrual method means that a business is likely to have a balance in accounts receivable (for credit sales) and accounts payable (for purchases it hasn’t yet paid for).
For example, suppose that in June a company deposits $2,000 into its checking account and writes checks to pay bills for $1,800. If you look only at the cash flowing in and out of the business, the company spent $200 less than it brought in, so it shows a profit of $200.
But what if, in June, the company also used a credit card it doesn’t intend to pay for until August to pay monthly bills in the amount of $1,000? Taking this transaction into account, the company actually spent more than it made, resulting in a loss of $800 ($2,000 in deposits less $2,800 in checks and credit card usage).
Distinguishing costs from expenses
When using the accrual method of accounting, one of the big distinctions you need to make and keep in mind is that costs aren’t the same as expenses. Take a look at the differences:
Costs: A cost is the money the company uses to produce or buy something — money that’s not available to use anymore. Costs are a use of company cash, be it to purchase inventory, make investments, or pay back debt.
Expenses: Expenses are costs directly applied to revenue-producing activities during a financial period. When spending is applied (or matched) with revenue, the spending becomes an expense.
Suppose a company buys a shipment of aluminum for $25,000 cash in order to manufacture lawn mowers to sell to customers. The aluminum is a raw material, which appears on the balance sheet as an inventory account. When the company buys the aluminum, the price it pays, or promises to pay, is a cost.
The company uses the aluminum to manufacture lawn mowers. When the lawnmower is sold, the cost of the aluminum used is reclassified as an expense (cost of goods sold). If the company uses half of the aluminum in production during the accounting period — and the lawn mowers produced are sold — the cost is $25,000, but the expense is only $12,500.
The remaining $12,500 stays in inventory until it’s needed to produce the product and the product is sold.
The statement of cash flows is so important; it ties together the costs shown on the balance sheet with the expenses shown on the income statement.