Treatment of Funds
The viewpoint of accounting relating to the funds of the firm is different from that of finance. The measurement of funds (income and expenses) in accounting is based on the accrual principle/system. For instance, revenue is recognized at the point of sale and not when collected. Similarly, expenses are recognized when they arc incurred rather than when actually paid. The accrual-based accounting data do not reflect fully the financial circumstances of the firm. A firm may be quite profitable in the accounting sense in that it has earned profit (sales less expenses) but it may not be able to meet current obligations owing to shortage of liquidity due to uncollectable receivables, for instance. Such a firm will not survive regardless of its levels of profits.
The viewpoint of finance relating to the treatment of funds is based on cashflows. Tile revenues are recognized only when actually received in cash (i.e .. cash inflow) and expenses are recognized on actual payment (l.e. cash outflow). ·This is so because the financial manager is concerned with maintaining solvency of the firm by providing the cashflows necessary to satisfy its obligations and acquiring and financing the assets needed to achieve the goals of the firm. Thus, cashflow-based returns help financial managers avoid insolvency and achieve the desired financial goals.
To illustrate, total sales of a trader during the year amounted to Rs 10,00,000 while the cost of sales was Rs 8,00,000. At the end of the year, it has yet to collect Rs 8,00,000 from the customers. The accounting view and the financial view-of the firms performance during the year are given below.
Obviously, the firm is quite profitable in accounting sense, it is a financial failure in terms of actual cash flows resulting from uncollected receivables. Regardless of its profits, the firm would not survive due to inadequate cash inflows to meet its obligations.