Accounting Net Income Flows

Accounting net income flows are the amounts reported on the income statement: the revenues, expenses, gains and losses that together produce a company's net income for a period. The phrase is used mainly in finance and capital budgeting to separate these accounting measures from the cash that actually enters and leaves the business.

Because US GAAP requires the accrual basis, income statement flows record economic events when they happen rather than when money changes hands. Revenue is recognized when it is earned, expenses are matched to the periods they help, and non-cash items such as depreciation reduce profit without any payment in that period. Analysts therefore treat accounting net income flows and cash flows as two related but different views of performance.

Think of a landscaper who mows a client's lawn in December and is paid in January. In the landscaper's accounts, the December income statement already shows the job, because the work was done then. The money itself arrives a month later. The income statement tells the story of work done and costs used up; the bank account tells the story of money in and out.

Over a long enough time the two stories end up close together, since nearly every sale is eventually collected and nearly every cost eventually paid. In any single month or year, though, they can differ a lot, which is why investors look at both.

The differences come from a few recurring sources:

• Credit sales and purchases. A sale on account increases revenue now and cash later, building up accounts receivable in between.
• Accruals and deferrals. Wages earned but unpaid are expensed before cash leaves; rent paid in advance is a cash outflow before it becomes an expense.
• Depreciation and amortization. The cost of a machine is spread over its useful life as depreciation expense, although the cash was paid when it was bought.
• Gains and losses. Selling equipment for more than its carrying amount produces a gain in income, while the whole sale price is a cash inflow from investing.
• Capital spending and borrowing. Buying assets or repaying principal uses cash but does not reduce income.

The statement of cash flows links the measures. Under the indirect method, the operating section starts with net income and adjusts it for non-cash items and changes in working capital to arrive at cash from operating activities.

A short example shows the idea. A company reports net income of $120,000, after depreciation of $30,000. During the year its receivables rose by $25,000 and its accounts payable rose by $10,000. Operating cash flow is $120,000 + $30,000 − $25,000 + $10,000 = $135,000. The $15,000 difference is entirely explained by timing and non-cash items, not by any error.

Capital budgeting methods such as net present value use cash flows, because only cash can be reinvested or paid to owners. Methods such as the accounting rate of return use accounting net income flows instead, which makes them easy to compute from budgeted statements but blind to the timing of money. Lenders and analysts also compare the two over several years. Net income that grows steadily while operating cash flow lags may point to aggressive revenue recognition or rising receivables, a concern summed up in the idea of quality of earnings.

Neither measure is "right" on its own. Accrual-based income flows show whether a business is creating value in the period, matching efforts to accomplishments under the matching principle, while cash flows show whether it can pay its bills. Sound analysis uses both and investigates large or persistent gaps between them.

Owners of small businesses that keep their books on the cash basis see only one stream, since revenue and expense are recorded when money moves. For them, net income and cash flow are nearly the same figure, which makes the books simpler but hides obligations and receivables that a full accrual set of statements would reveal.

• Financial Accounting Standards Board