Briefly explain the difference between "cash”, "net profit" and "gross profit".
There are two methods in accounting for business transactions: 1) Cash Based Accounting, and 2) Accrual Based Accounting.
Under Cash Based Accounting, transactions – whether revenues or expenses are only recognized and recorded when cash is exchanged. Under this method of accounting, if a sale occurs on July 1st for example, and cash is received on July 15th, the sale is recorded only on the 15th when cash is received. The cash basis often leads to misleading financial statements. It fails to record revenue that has been earned but for which the cash has not been received. Also, expenses are not matched with earned revenues. Cash-basis accounting is not in accordance with generally accepted accounting principles (GAAP).
Under Accrual Based Accounting, transactions are recorded in the period in which the event occurs. For example, using the accrual basis to determine
net income means recognizing revenues when earned (rather than when the cash is
received). It also means recognizing expenses when incurred (rather than when
paid). Information presented on an accrual basis reveals relationships likely to be
important in predicting future results. Under accrual accounting, revenues are recognized
when services are performed, so trends in revenues are thus more meaningful
for decision-making.
One thing to note here is that (as mentioned above) Cash-basis accounting is not in accordance with generally accepted accounting principles (GAAP), therefore all financial statements are prepared under Accrual Based Accounting which is why when we prepare the Statement of Cash Flows, Net Income is adjusted to Net Cash.
Having said that, Cash is defined as “An item on the balance sheet thatreports the value of a company'sassets that are cash or can be converted into cash immediately. Examplesof cash and cash equivalents arebank accounts, marketable securities and Treasury bills.”
Gross Profit is defined as “The amount of money left over from revenues after accounting for the cost of goods sold.”
Net Income is defined as “A company's total earnings (or profit)- often referred to as “the bottom line” since net income is listed at the bottom of the income statement. After gross profit is calculated, operating expenses are deducted to determine net income (or net loss). Operating expenses are expenses incurred in the process of earning sales revenue. Examples of operating expenses are sales salaries, advertising expense, and insurance expense. The operating expenses of a merchandiser include many of the expenses found in a service company.
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