What Is Cash Flow

One basic principle in accounting requires the recording of revenue when the economic activity that generates it is substantially completed. In most cases this happens when the product is shipped or the service rendered. If there is a significant time lag between substantial completion and actual payment, then waiting for actual payment before recording the revenue necessarily
introduces a distortion.

A similar distortion would be introduced on the expense side if, for example, inventory is expensed only when the supplier is paid. That would mean the inventory is never recorded as an asset. It would also mean that if the inventory is used in a separate accounting period from the one in which it is
paid for, a related basic accounting principle—the matching principle—would also be violated. This principle requires that all of the expenses associated with producing revenue in a period be recorded in the financial statements of the same time period. From both an accounting and an IRS point of view, cash-basis accounting is permissible only in businesses that are so simple that cash accounting would not distort results.

In the vast majority of businesses, accrual-based accounting has been adopted as the required method. And this is the point at which problems of terminology and understanding about cash flow begin. Instead of recording everything based on the movement or flow of cash, as in cash-basis accounting, accrual-based accounting measures the flow of value. But the flow of cash and the flow of value are quite different in several material respects. It is crucial, therefore, to get behind the details of accrual accounting to understand what happened in cash terms.

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What Is Cash Flow