Welcome back! In Chapter 1, we studied that the Income Statement shows profit while the Cash Flow Statement shows money. What causes the difference between those two numbers? It occurs when a business chooses to make a record of its transactions. Let's explore the timing of cash flows.
Picture your landscaping company ownership. On May 1, you mow the corporate lawn for $5,000. You send your client an invoice, and in return, they promise to pay you in 30 days (June 1).
Did you earn profits in May? The response relies on the accounting method you adopt:
1. Cash Accounting (The Simple Way)
With the cash accounting method, a transaction is recorded when cash physically changes hands. Using this methodology, your May entry will reveal $0 because you haven't received payment yet. When the check goes through in June, you will record the $5,000 revenue. Although this method is good for recording your bank balance, it is not good for recording your actual May work effort.
2. Accrual Accounting (The Business Standard)
Accrual accounting records transaction when the event happens, regardless of the cash movement. During May, the work was completed and, therefore, $5,000 is recorded as Revenue for the month of May. Also, you include an Account Receivable (money owed to you) on your Balance Sheet as an Asset.
The majority of medium and large enterprises utilize accrual accounting. What is the reason? As it provides a more accurate picture of business activity. The review of the accrual income statement belonging to the month of May shows the entity was highly active and profitable!
Your Income Statement may say you made $5,000 in May, but your bank account says you are at $0. This is a dangerous blind spot. This is the primary reason behind the “Profit vs. Cash” gap.
Accrual accounting certainly provides managers with a clever insight into their performance, but it does not show the bank account truthfully. The first step to financial mastery will be the understanding of this timing difference. Let us reinforce this idea through a brief activity!