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Fundamentals of accounting
Fundamentals of accounting

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1.3 Income and expenses in accounting

An important aspect of double-entry accounting is that income and expenses are recognised when they occur (and not when cash is paid or received) and then reported in the financial period to which they relate. Consider a credit sale that occurs in the annual accounting period ending 31 December 2016 but payment is only received by the customer the following year. Such a sale is recognised and reported in the accounting period in which it takes place whether or not cash has been received by the end of the period.

All businesses have to also keep track of their cash flow (the fourth fundamental question). Such a record details the cash coming in and out of the enterprise and is summarised, like the income statement and balance sheet, in a report at the end of each accounting period. Cash is just one asset of a business but is often described as the most important asset as it is the only one that can be used to pay debts at very short notice. Other assets, such as goods for sale or property, have to be sold first before any cash proceeds can be used to pay any debts owing.

The next activity should give you an insight into the common situation in business where the profit made in a period is not the same as the cash generated in the same period. In order to compare your responses to the answers, you will need to enter text into the boxes below. You will then be able to click on ‘Save and reveal answer’.

Activity 2 Understanding the difference between profit or loss and positive or negative cash flow

Andrew and Barry have recently started exactly the same business – buying and selling music CDs. They each started their trade on 1 January 20X1 with £1,000 entirely borrowed from the bank. Both Andrew and Barry bought their CDs for cash but Andrew decided to allow his customers to buy CDs on credit as he believed this would generate more sales.

In the first week of trading Andrew bought CDs for £800 – all cash – and sold them all for £1,600 – all on credit. Barry, on the other hand, bought CDs for £400 – all cash – and sold them all for £800 – all cash.

  1. Assuming that Andrew and Barry had no other income and expenses in the week, calculate each of their profit for the week.
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Answer

Andrew’s profit for the week = £1,600 (credit sales) – £800 (cash purchases) = £800.

Barry’s profit for the week = £800 (cash sales) – £400 (cash purchases) = £400.

  1. Assuming that Andrew and Barry had no other transactions in the week, calculate each of their cash generated for the week.
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Answer

Andrew’s cash generated for the week = (£1,000 – £800) – £1,000 = –£800 (i.e. the business has a negative cash flow of £800 in the week).

Barry’s cash generated for the week = (£1,000 + £800 – £400) – £1,000 = £400 (i.e. the business has a positive cash flow of £400 in the week).

  1. What do your answers to (a) and (b) tell you about the effect of credit sales on profit earned and cash generated in a business?
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Discussion

The answers tell us that credit sales may generate more profit in a period (Andrew’s profit compared to Barry’s) at the expense of losing cash (Andrew’s negative generation of cash compared to Barry’s). From the activity above we have seen that it is possible for a business to make a profit in a period but lose cash in the same period.

It is widely known that profit is the difference between total income and total expenses in a business. What is less well-known is that the overall accounting value of a business is the difference between total assets and total liabilities as recorded in the balance sheet. This overall value is known as the net assets, net worth or capital of the business.