Statement of Cash Flows; Accrual Basis vs. Cash Basis Accounting; Cash Basis of Accounting

The cash basis of accounting recognizes sales revenue when cash is received and recognizes expenses only when payments are made.  Small businesses are drawn to the cash basis because of its simplicity.  In contrast accrual accounting recognized revenues when they are earned rather than when they are collected, and recognizes expenses when they are incurred.  Thus, the accrual method of accounting is consistent with the Matching Principle since revenues are matched with the expenses incurred to generate the revenues in the same accounting period.  Most companies use accrual accounting. 

The Statement of Cash Flows measures the flow of money in and out of a business.  It is a financial statement that shows how changes in balance sheet and income statement accounts affect the amount of cash and cash equivalents a company has on hand.  The cash flow statement reports the cash generated and cash used during the time indicated on the statement itself.  The importance of available cash to a debtor company is obvious from a trade creditor's point of view. Specifically, debts can only be paid in cash. 

Since most companies do not use the Cash Basis of Accounting, the Statement of Cash Flows allows creditors to see if customers or applicants are accumulating cash or alternatively are reducing the amount of cash on hand.  As such, the Statement of Cash Flows offers unique insights not available to credit professionals in any other statement or document.

Credit professionals often do not request or receive a Cash Flow Statement, and as a result the creditor company does not have information that may be important in deciding whether to extend credit, how much credit to extend, and what payment terms to offer an applicant or customer.  For example, most companies prepare their income statements under the accrual basis of accounting.  This means that revenues reported on the income statement may not have been collected. Also, under the accrual method expenses reported on the income statement might not yet have been paid.

The Cash Basis of accounting is one in which revenue and expenses are recorded in the period in which they are actually received or expended in cash. Use of the cash basis generally is not considered to be in conformity with generally accepted accounting principles since it is usually a violation of the Matching Principle (see Matching Principle).

Cash flow analysis using the Statement of Cash Flows shows the affect of business operations measured in terms of cash inflows and outflows, and from that perspective is illuminating to credit professionals interested in knowing whether customers or applicants are (a) accumulating cash or (b) spending cash.  Cash flow analysis compares the timing and amount of cash inflows with the timing and amount of cash outflows. A firm's cash flow position can greatly affect its ability to pay invoices as they come due and remain in business.

© 2011 by Michael C. Dennis.  All Rights Reserved.  Mr. Dennis is a consultant.  He can be reached by email at mcdennis13@yahoo.com