Profit Does Not = Cash

Mar 20, 2014

Recently, I was talking with one of my new business tax return clients and she commented to me that she realized she had a tax profit this year but it did not seem to have much to do with her cash. We have scheduled a meeting to discuss this with her further. I am sure many of you have had this same issue. What answer would you give?

There are many different ways to determine what your “profit” is for the year. There is GAAP reporting that would calculate profit a certain way, accounting for accruals, prepaids, depreciation over longer periods than tax, etc. Then there is tax reporting that may be similar to GAAP, but most certainly would have accelerated depreciation methods. Tax may also be on a cash basis where the accruals and prepaids, receivables, and payables would need to be reversed. Then of course there is management profit, which may still be a different number. Which number is right is only relevant for what you are trying to do. If you are doing a tax return, then you need to determine your taxable profit, or loss. If you are having an audited financial statement then GAAP basis profit, or loss, would be necessary. Neither of these may be the best methods to look at to make management decisions.

Many things effect our profit. In a manufacturing environment, you may be costing your product ineffectively which is effecting your bottom line. You may also have excessive inventory at the end of the year that you are unable to expense and have not sold, which again effects your bottom line and cash. You still spent the money to build the inventory, you just have not sold it to recognize profit, or the full expense.

Other simple reasons exist as well. If you are a company with a large amount of debt the principle payments of that debt is not an expense but it most certainly takes cash. If you pay a lot of your debt, you may still have a high profit, because the cash was not left for deductible expenses. Also you may be a cash basis taxpayer where your receivables have dramatically decreased from the prior year, which will add income to your bottom line, etc.

It is important to realize what your goal is and what rules you should be following for that goal, and understanding income does not necessarily equal cash flow.

Categories: Cost Accounting