The key difference between the income statement and the operating cash inflow/outflow of the statement of cash flows is accrual accounting. The income statement uses accrual accounting while the cash flow statement uses the cash accounting.

Accrual accounting recognises income and expenses when they are realised. In other words revenue and expenses should be recognised in the income statement when they can be reliably measured and economic benefits have or will likely be transferred to the buyer. This means that revenue, for example, will be recognised even though the benefits (which are normally cash) may occur at different times.

On the other hand, cash accounting recognises revenue and expenses only when cash is paid or received. For example, a company sell goods on credit. It sells $100,000 of stock in year 0. 50% is paid in Y2 and the other 50% the following year. The following transactions in the income statement and operating cash flows statement would occur.

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Furthermore, the income statement also includes non-cash expenses such as depreciation and Amortisation. Depreciation and amortisation are a non-cash transaction. However they do represent a reduction in assets economic benefits in a period. For this reason, it is included in the income statement but is excluded in the cash flow statement.

Using accrual accounting creates a number of working capital accounts (inventory, accounts payable, prepaid expenses).  As you can see in the above example, accrual accounting creates the working capital account – accounts receivable. This is a useful aspect of accrual accounting as it represents obligations to pay cash in the future and receivables for future cash inflows.

In conclusion, cash accounting and accrual accounting both have their benefits. A summary of their benefits are listed below:     

Cash Accounting: Simple and provides a liquidity perspective

Accrual Accounting: inform users not only of past transactions involving payments and receipts of cash but also of obligations to pay cash in the future and of receivables for future cash inflows. Furthermore it recognises economic benefits when they are generated / used up

Below are some examples that recognise the difference between accrual accounting and cash accounting:

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