Question

     Elaborate on the following statements:

          It's wrong to say "Profit = Increase in Cash"

          It's correct to say "Profit = Increase in Net Worth"

Answer 1

It is wrong to say “Profit = Increase in cash”

Explanation: The profit is calculated as per the accrual concept which states that the revenue should be recognized when it is earned not when it is received and the expenses should be recorded when they are incurred not when they are paid. Therefore, it considers the credit transactions into account while calculating the profit. Whereas, the increase in cash can only be resulted from the inflow of cash in the business.

Example: A company purchases goods on credit for $100,000 and sold it for $200,000 on credit. It incurred the expenses of $30,000 which is not paid and still due.

Profit: The profit of the company is $70,000 ($200,000 - $100,000 - $30,000) as the items are recorded when they are incurred and earned.

Increase in cash: The increase in cash is zero because there is no cash involvement in the transaction. The goods are purchased on credit and no money was paid to supplier. The goods are sold to customer on credit which means no money is received from customer. The expenses of $30,000 are incurred but not yet paid in cash.

Thus, there is no cash movement for this transaction and the increase in cash in zero. Whereas, the profit is $70,000.

It is correct to say “Profit = Increase in net worth”

Explanation: The net worth is calculated by subtracting the liabilities from assets. It can be stated that it is the sum of owner’s or shareholders’ equity and retained earnings. The net profit of the company is transferred to retained earnings account. Therefore, it increases the net worth of the company by increasing the retained earnings.

Example: The retained earnings balance of a company is $100,000. The shareholders’ equity is $150,000.

The company earns the profit is $80,000. It will be transferred to retained earnings. Thus, the retained earnings balance will be $180,000 ($100,000 + $80,000). Now, the net worth after profit will be as follows:

The net worth increased from $250,000 to $330,000 when the profit is $80,000. Therefore, the net worth increases with the profit.

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