Question

As to accrual accounting, revenues (expenses) are recorded when they occur not when cash is received (paid), that is the main reason why profit is different from net cash flow from operating activities. Then, how to reconcile a firm's net profit to its net operating cash flow, and explain why?

Answer 1

Accrual Basis Of Accounting

According to the Accrual Basis of accounting the expenses and revenues must have to be recorded as and when it is incurred irrespective of the fact that it is paid or received in cash or not. Lets take an example, suppose Comapany A has incurred electricity expense of $1000 but the amount is not paid by the company. Now, as per the accrual basis of accounting it will Debit Electricity Expense by $1000 and will Credit a liability of $1000 as Outstanding Electricity Expense. As well as in accrual basis of accounting there is some non-cash items for which no cash is paid by the comapny. Depriciation expense and Amortization expense are that type of items.  In the accounting world the result of a business i.e Profit or Loss is always determined on accrual basis.

CashFlow Statement

On the other hand the Cashflow Statement is created on cash basis. Means the cashflow statement always record the transaction, cash for which is received or paid. We can say cashflow statement as a condensed cash book or cash ledger. In the cash book we record all the cash transactions. The same thing happens in the case of the Cashflow. The only difference between the cash ledger and the cashflow statement is we divide the transactions of the cash ledger into three activities of the organisation i.e Opearting Activities, Investing Activities and Financing Activities in the Cashflow Statement. Now in the Cashflow Statement no Adjustment Entry is made for any Outstanding or Prepaid Expense or for any Advance or Accrued Revenue. Cause no cash is paid or received for this transaction. As well as no Non-Cash item i.e Depriciation or Amortization expense is entered in the Cashflow Statement.

Reasons for Difference between Profit on Accrual basis and Cash from Operating Activities and how to reconcile this difference

We have understand what is Accrual Basis Of Accounting and The Cashflow Statement. Now, we will understand the reasons behind the difference of Profit on Accrual basis and Cashflow from Operating activities.

Due to the following reasons the profit on accrual basis and Cash from operating activities are different.

(a) Non-Cash Items -

We know that in the accrual basis of accounting the non-cash items are recorded. That means we record the depriciation and amortization expense in the accounts as per the accrual basis of accounting. But in the casflow from operating activities we do not record depriciation or amortization expense cause no cash is paid for depricition or amortization by the company. Due to this reason the profit on accrual basis comes is less than the cashflow from operating activities or we can say that cashflow from operating activities is greater than the profit from accrual basis.

Now if we want to reconcile the profit on Accrual basis and cashflow from Operating Activities then we has to do the following thing-

To Get the Amount of Cashflow from Operating Activity = Profit on Accrual Basis + Depriciation Amount.

To Get the Amount of Profit on Accrual Basis = Cashflow from Operating Activity - Depriciation Amount.

This same thing applies while we prepare Cashflow in Indirect method. Under Indirect method we want to get the amount of Cashflow from Operating Activity by adjusting  the Profit on Accrual Basis. Due to this reason we add Depriciation with the Profit to mitigate the difference between the profit and the cashflow from operating activity.

Adjustment Entry-

Under accrual basis adjustment entries are made but no such entry is made while we prepare the cashflow statement. This is an another reason for which a difference takes place between profit and cashflow from operating activity. We also has to adjust this entries if we want to reconcile the amount of profit and cashflow from operating activities.

Now if we want to reconcile the profit and with the cashflow from operating activities then we must have to do the following things-

To get the Cashflow from Operating Activities from Profit

(a) Less the increase in Current Assets from the profit.

(b) Add the decrease in Current Liabilities with the Profit.

(c) Less the decrease in Current Liabilities from profit.

(d) Add the increase in current liabilities with the profit.

We just have to do the opposite thing while we want to get the profit from the Operating Cash flows.

(C) Other Non-Operating Items -

There are some expenses and incomes which is not part of operating activities but which is included in the profit. The examples of these type of items are Dividend paid, Interest paid, Loss on sale of assets, Profit on sale of assets etc. All these items are considered while we determine profit on accrual basis. But these items are excluded while we want to know the amount from the Operating Activities. So these items also has to be adjuted.

The Non-Operating Expenses must have to be added with the Profit on Accrual Basis and Non-Operating income must have to be deducted from the Protit on Accrual Basis.

The opposite thing must have to be done while we want to reconcile the Operating Cash with the Profit on Accrual Basis.

The above mentioned adjustment are done to get the amount from the operating activities with the profit on accrual basis while we prepare the Casflow Statement on Indirect method. But in the case of Direct method we have the direct amount of payment made to creditors or amount received from the debtors. Thats why no adjustment is required while we prepare the Cashflow Statement in Direct Method.