Accounting Profits vs Cash Flow Homework Help & Tutoring
Accounting Profits vs Cash Flow Assignment Help:
Capital budgeting or capital expenditure decisions pertain to fixed assets or long
term assets which by definition refer to assets which are in operation, and yield
a return over a period of time, usually exceeding a year. The capital budgeting,
therefore involves a current outlay or series of outlays of cash resources in return
for an anticipated flow of future benefits. These future benefits can be measured
by the ways of calculating accounting profits and cash flows. The main difference
between accounting profits and cash flows is the existence of non-cash item such
as depreciation in the accounting profits. Therefore, the accounting profits have
to be adjusted for non-cash expenses and incomes to arrive at the cash inflows.
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Why Cash flows are preferred to Accounting profits?
- In any project, the timing of cash outflows and inflows are very important. There is time value for money. Any project should be appraised based on the timing of cash flows. There is a difference between $5,000 received in the 1st year and the same amount received after 10 years. Hence the importance of time value of money. The cash flow method considers the timing of cash inflows and outflows and discounts those flows according to the time of occurrence. Whereas, accounting profits ignore the time value of money. As per the accounting profit, profit is generated once you sell the goods and not when you realize payment for it. If you receive the payment in advance or at the time of sale, you can very well re-invest in the business when a good opportunity arises. Isn’t it?
- For capital budgeting analysis, investment is in the form of cash outflow. So, naturally the management needs to compare the costs(outflows) and benefits(inflows) arising out of the project. This can be effectively measured only by means of cash flow method. You need cash to buy an asset. It is an outflow. But accounting profit method, ignores expenditure of buying asset at the time of purchase. It records the expenditure of an asset over the entire economic life of the project in the form of depreciation, which is a non-cash item. Hence, even in this case, time value is ignored. The accounting profit does not reflect the requirement of cash at outflow and inflow stages of time. Moreover, this does not actually reflect the actual outflows and inflows. So, only the cash flow method is the right choice for evaluating a capital budgeting decision.
- In cash flow method, there is only one way of calculation: cash outflows and cash inflows would be considered. Whereas, accounting profit calculation involves several ways of calculation. There are various principles in accounting which can be followed and ultimately would result in different profit calculations. For example, one may depreciate an asset using straight-line method, residual method, units of usage method etc. In another case, you may value an inventory either by using LIFO, FIFO or average cost method. All these will result in different profits in respective calculations and cash flow method avoids all these differences.
Because of all the above reasons, we can say that Cash flow method is the most appropriate method for evaluating investment decisions and capital budgeting.
