There is always a confusion
between Net Income and cash flow and the accrual basis of accounting will help
us to clarify these two terms in accounting. Recognizing revenue when it is
earned and expenses when the related goods or services are used, is the accrual
basis of accounting. The purpose is to measure the profitability of the
economic activities conducted during the accounting period.
The concept used is the
matching principle, where revenue is offset with all the expenses incurred, in
order to provide a measure of the overall profitability of the economic
activity. Net Income is the revenue recognized less expenses, or the cost of
goods sold that went into so as to bring in that revenue recognized in the same
period.
Furthermore, other expenses
such as research and development, depreciation and amortization, taxes,
overhead costs, interest payments on debt also get subtracted. Extraordinary
items such as gains or losses from the sale of assets, and impairment charges
(that is a reduction in value in the company’s total capital, like fixed
assets, thus reduce its values on the company’s books) are taken into account
and the result is Net Income.
Some of the items mentioned
above are non- cash items like depreciation, or a company can recognize revenue
even if it has not collected payment from the customer. The result is a Net
Income that does not reflect the amount of cash actually generated in a period.
Cash Flow, or net cash flow,
is the net change in the amount of cash that a business generates or loses. Net
cash flow is calculated by determining changes in ending cash balances from one
period to the next, and is not affected by the accrual basis of accounting. If
a company earns revenue in December but allows the customer to pay in 30 days,
the cash from the sale of December will be received in January. In this case,
revenue from December will increase net income of December, but WILL NOT
increase December’s net cash flow.
Another example is say a
retailer who purchases and pays for merchandise in March. However, say that the
merchandise remains in inventory and is sold in May. Net cash flow will
decrease in March since cash is paid out to buy the merchandise, but net income
decreases in May when the cost of goods sold is matched with May sales.
Given the above, the
differences between net income and cash flow are the following:
·
When calculating net income expenses are
included even though no cash payment may have yet been paid.
·
Cash payments for costs incurred may be
recorded as assets, since they have yet to be used up.
·
Revenues are not included in net income
because that have not been earned, even though the related cash has been received.
·
Revenues are included in determining net
income because they have been earned, even though the cash has yet to be
received.
In
conclusion, net income, or accounting income, and cash flow will be different.
That does not mean that one is wrong and the other correct. It reflects the
fact that the way one is calculated is different and both measures give
valuable information about the company.
