Cash vs Profit
Using "profit" to measure business performance has dominated business reporting for centuries, and yet you still hear "cash is king". The best decision-making techniques emphasise cash flow, not profit, and the theory of company valuation is based on cash flows. What is the difference between cash and profit, and why is the profit technique so widely used for reporting?
Surplus and deficit
Your business earns sales. It has expenses. As a result, it has either a surplus or a deficit. This result can be measured as a cash result, or as profit. Sometimes, you can make a profit but lose cash, or the other way around. Both cash and profit are useful numbers, but they answer different questions.
If we simply record business transactions the moment cash changes hands, we get a cashflow result. If we make an effort to delay or bring forward the timing of these events in certain ways, we end up with a "profit" or a "loss". The "Profit or Loss" is an artificial number which is different to the cash movements in your bank account.
Accountants sometimes say that cashflow is a fact and profit is an opinion. Yet profit is very useful because timing effects can make it hard to see the true progress of a business. For example, if a cafe invests in a $10000 coffee machine and pays up front, the cash flow will be terrible in the month of the purchase, and much better later on. The profit method of accounting spreads that cost out over the lifetime of the coffee machine ('depreciation'), which makes it easier to understand the true performance, month on month. Basically, cash flow is a very short term view, and profit is a longer term performance measure.
The logic of depreciation
The reason for depreciation is to compare performance when a long term investment decision affects multiple years.
Imagine a Russian fairy tale, where a mother and father have spent years running a cafe in the middle of a dark forest, popular with various passing princes, princesses, witches etc. Finally the couple are preparing to hand over the cafe to the next generation. Their children are Nikita, Ivan. They decide to let each child run the cafe for a year each, and at the end of the two years decide on the best manager. They use cash-book accounting.
Nikita goes first. She knows that times are changing in the cafe business. The cafe is at risk of losing business to a new competitor opening soon, so she invests $5000 in a fancy Italian espresso machine, and $5000 in cafe wifi (paid up front in cash). Each asset lasts five years. Her investments stop any loss of business to the new competitor, so sales remain stable (which is a remarkable achievement; without her investment sales would have fallen by 30%). She finishes year with sales of $100,000. Her gross margin is $70,000. With various other overhead costs of $50,000, the bank account grows by $10,000 over the year (including the $10,000 paid for the new assets).
Then Ivan takes over. The cafe performs exactly the same, but he doesn't need to buy the assets again, since they last for five years. Therefore, he returns a cash surplus of $20,000, double his sister. Mother and Father decide that Ivan is the better cafe manager.
This is unfair. Nikita's year 1 performance was hit by her investment decisions, and Ivan in year 2 was able to "freeload" on her decision.
It's better to spread the cost of long-life assets over multiple years. That's what depreciation is. There are complicated ways to work out how to spread it, but often the best is to estimate the lifetime of the asset and spread it evenly over those years. Sometimes we allow for a "scrap" value at the end of the lifetime.
Why the tax office loves depreciation
Without depreciation, businesses would record the full cost of assets as an expense when they happen. In the case of Nikita, this made her cafe profit seem much lower than her brother. This was not good for her, but it did mean the cafe paid less tax in the first year. Tax authorities don't like this. The effect of depreciation is to increase profit in the first year, which means more tax. The tax authorities like depreciation so much that in many countries it is compulsory to use it. Further, the tax office will tell you how quickly you can depreciate the asset. If you work through the numbers, you will see that the total profit over the lifetime of the asset is the same with and without depreciation. The difference is only timing. But tax authorities want tax now, not next year.
The profit method tracks events which lead to future cashflows
The profit method also lets you track transactions earlier than the cash method, which makes it a more complete record-keeping system.
Consider how you report sales when selling on credit. In the "profit" system, you record the sale when you invoice the customer, even if you give her 30 days to pay. In the "cash" point of view, you wouldn't recognise the sale until she paid you. It also works for supplier payments: the "profit" system records the expense when you get the supplier invoice. The cash-book method waits until you pay.
Therefore the cash method fails to record the important point that someone owes us money, and it can't record when we need to pay someone in the future. For managing cash flow, cash book accounting is too simple for most small businesses. You end up resorting to spreadsheets and other record keeping to cover the gaps.
On the other hand, by recording the sale before you get paid, you express an opinion that you will be paid in the future, but there is no certainty. This is also a source of a basic accounting fraud: all you need to do to get a profit is generate false invoices. This results in high sales and good profit. The bank account does not reflect any payments, but the Profit and Loss report does not concern itself with the bank account (the Balance Sheet does).
The use of timing corrections is very useful for understanding business performance. Technically "Profit" accounting is called "accrual" or "double-entry" accounting. The system is older than the Mona Lisa and was introduced to the business world by the same person who finally convinced Europeans to give up Roman numerals and swap to the Indian system we use today. Hats off to Luca Pacioli.
Some businesses use both cash and profit: profit for internal reporting, and cash for GST and Tax. For GST, you can get a cash flow advantage by choosing your method carefully ... the subject of another blog post. Meanwhile, that concludes our overview of the first year of an accounting degree.