What’s the Difference Between Profit and Cash Flow?
Financial Statement Rules: All audited financial statements are prepared according to rules
established by the accounting profession and governmental agencies. These Generally Accepted
Accounting Principles (GAAP) are developed by a non-profit organization of the accounting profession
called the Financial Accounting Standards Board (FASB).The securities regulatory bodies of
different nations (Securities and Exchange Commission or SEC in the USA) also require that the
financial statements of all public companies be prepared according to GAAP. These rules are also used
by the IRS and other government entities to calculate income taxes owed by businesses.
Financial Accounting Standards Board (FASB)
Creates Accounting Rules called:
Generally Accepted Accounting Principles (GAAP)
All public companies must use GAAP rules as required by:
IRS
SEC
(Internal Revenue Service)
(Securities & Exchange Commission)
Tax Reporting
Financial Reporting
Booking Revenue and Expense: These accounting rules are accrual based and result in recording
(“booking”) revenues and related expenses at the time the transaction occurs—not when Cash is
received or expended. Accrual accounting “matches” revenue with expenses. A company must recognize
expenses associated with a transaction’s revenue at the time the transaction revenue is booked. The
components of Profit are Revenue and Expense—which are calculations according to GAAP rules.
Profit is a calculation according to GAAP: Revenue ─ Expense = Profit
Profit is created
by transactions as Revenue and Expenses are recognized (booked).
Cash Flow is created by collections and disbursements of Cash.
Profit or Net Income on the Income Statement is therefore NOT the same as Cash Flow, calculated on
the Statement of Cash Flows. The Income Statement has nothing to do with Cash Flow; you cannot
tell from the Income Statement alone how much Cash Flow the company generated during the period.
The Statement of Cash Flows is necessary for this analysis.
Cash Flow from operations, shown on the Statement of Cash Flows, represents the difference between
cash actually received (collected), and cash paid out in the normal core business activities.
Revenues and expenses are reported on the Income Statement according to GAAP (accrual)
accounting rules when they are recognized from transactions.
To calculate PROFIT according to GAAP, we must:
1. Deduct from revenue the expenses that are not paid in Cash—such as depreciation and
amortization.
2. Recognize revenue not received in Cash—such as sales made on account receivable.
3. Not deduct as expense certain Cash disbursements—such as inventory and pre-paid charges.
4. Not recognize as revenue certain Cash receipts—such as backlog deposits or pre-paid accounts
from customers.
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Depreciation and Amortization
Depreciation and amortization are expenses according to GAAP deducted from revenue to calculate
Profit—but they are expenses not paid in Cash. Depreciation is the expense recognized by a company
each year over the useful life of a capital asset that more fairly represents the ongoing expense of using
the asset rather than the one-time up-front disbursement of Cash to acquire the asset.
Do not confuse financial depreciation and amortization expense with (1) the loss of value of an asset
over time (economic depreciation), (2) deterioration in physical condition (physical depreciation), or (3)
functional obsolescence (functional depreciation). On a company’s Income Statement, depreciation or
amortization expense is an accounting calculation representing the original cost of an asset deducted
over time rather than deducted all up front when it is purchased or acquired.
Depreciation pertains to the expense taken over time of a tangible capital asset (large investment in a
physical asset that is used over time—such as a building, manufacturing plant, large equipment,
vehicles, etc.). Amortization pertains to this same idea but is the expense deduction applied to intangible
assets (copyrights, patents, intellectual property, certain software or R&D, etc.).
Example: If we buy a building for $20 million, the Cash is paid out now. However, according to
accounting rules, the building might have a useful life of 20 years (there are tables used by
accountants with the useful life of all types of assets). Therefore, when we pay $20 million Cash for
the building, the Cash is disbursed now—but we deduct depreciation expense of $1 million per year
for 20 years—and no more Cash is disbursed each year even though we show a $1 million
depreciation expense each year. At the end of 20 years, we have written off the entire cost of $20
million for the building—but we still own the building. On our Balance Sheet, the building is shown
valued at zero, because we have fully depreciated the asset. However, in the real world, if the real
estate market has been good, the building might actually be worth $25 or $40 million or more.
Valuing Assets: Balance Sheet accounting rule: GAAP accounting rules require that Assets be
carried on the Balance Sheet at the lesser of original acquisition price (less depreciation) or current fair
market value. This is for conservative reporting purposes. Thus the value shown for Assets on a Balance
Sheet might have little relationship to their actual fair market value in the real world. If an asset (say, our
building above) were purchased for $20 million and in three years has recognized $3 million in
depreciation expense, it would be carried at $17 million on the Balance Sheet—while the hot real estate
market makes it actually worth $25 million.
However—if the real estate market has badly collapsed, and the building after three years is now actually
worth only $14 million in the real world, the auditors would impair the value of the building and show a
special impairment charge on the Income Statement of an additional $3 million (plus the $3 million
accumulated depreciation) so that the building is carried at the fair market value of only $14 million. If the
real estate
© 2014 Acumen Learning, LLC. All rights reserved. 8-1-14