Why the Cash for the Business Does Not Equal to the Profit

1079 WordsMay 13, 20125 Pages
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.…show more content…
The estimate is based on the likely cost to be incurred in the future rather than the present. One typical type of provisions is bad debts that does not affect cash, but decreases the current asset receivables and increases the expense with a corresponding decline in profit. As the company foresees that the customer experiences the difficulty in paying back the money, the provision account has to set aside certain amount of money to account for the bad debts that is likely to be incurred, which brings the negative impact on profits and no impact on cash ultimately. A further example against the reconciliation between the cash flow and the profit is depreciation, which is also one important type of provisions. In accrual accounting, depreciation (or amortization) is an expense where no cash is outlaid but the expense is shown with a corresponding decrease in profit. Depreciation, which is used to distribute the cost of assets to write off the value of each fixed asset over its expected life span, comprises the usage for tangible assets such as buildings, equipments, and infrastructures (not the land) as well as for intangible assets, such as goodwill and patents, etc. For example, if a machine is bought for $100,000 with a life span of 10 years, then the depreciation cost of $10,000 of the machine is spread to each year, rather than charging $100,000 in the first year and nothing in the next 9 years. Therefore, the corresponding profit will be
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