Definition of Profit
Under the accrual basis of accounting, profit is the amount of revenues earned minus the amount of expenses incurred. Note that revenues are not receipts, and expenses are not payments.
Examples of Profit Without Cash
Assume that a company uses the accrual basis of accounting. In its first month of operations, it provides $10,000 of services to its clients and allows them to pay 30 days later. It also incurs $2,000 of expenses of which it pays $1,100 immediately and will pay $900 in 30 days. In its first month, the company had a profit of $8,000 (revenues of $10,000 minus $2,000 of expenses), but its cash decreased by $1,100 (cash receipts of $0 with cash payments of $1,100). If it has no other business transactions, the company’s profit in the second month will be $0 (no revenues minus no expenses) but it will have a $9,100 increase in cash (receipts of $10,000 minus payments of $900).
Now assume that a different company had a profit of $60,000 in its first year, but paid out $65,000 near the end of the year to acquire equipment that will be put into service on the first day of its second year. During its first year the company had $65,000 of profit, but may end the year with $0 cash.
Other examples where cash is paid out, but the profits are not reduced at the time of the payment, include prepayments of insurance premiums, payments to increase its inventory of merchandise, and payments to reduce liabilities.
To help recognize the difference between a company’s profits and its cash flows, the statement of cash flows is one of the required external financial statements.
