Why are accounting earnings different from cashflows

Accountants have invested substantial time and resources in coming up with ways of measuring the income made by a project. In doing so, they subscribe to some generally accepted accounting principles (GAAP). Generally accepted accounting principles require the recognition of revenues when the service for which the firm is getting paid has been performed in full or substantially, and has received in return either cash or a receivable that is both observable and measurable. For expenses that are directly linked to the production of revenues (like labor and materials), expenses are recognized in the same period in which revenues are recognized. Any expenses that are not directly linked to the production of revenues are recognized in the period in which the firm consumes the services. While the objective of distributing revenues and expenses fairly across time is a worthy one, the process of accrual accounting does create an accounting earnings number which can be very different from the cash flow generated by a project in any period. There are three significant factors that account for this difference.

1. Operating versus Capital Expenditure

Accountants draw a distinction between expenditures that yield benefits only in the immediate period or periods (such as labor and material for a manufacturing firm) and those that yield benefits over multiple periods (such as land, buildings and long-lived plant). The former are called operating expenses and are subtracted from revenues in computing the accounting income, while the latter are capital expenditures and are not subtracted from revenues in the period that they are made. Instead, the expenditure is spread over multiple periods and deducted as an expense in each period - these expenses are called depreciation (if the asset is a tangible asset like a building) or amortization (if the asset is an intangible asset like a patent or a trade mark).

While the capital expenditures made at the beginning of a project are often the largest and most prominent, many projects require capital expenditures during their lifetime. These capital expenditures will reduce the cash available in each of these periods.

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Lessons From The Intelligent Investor

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