CSLB Law & Business ExamBusiness FinancesMedium
A contractor's income statement shows a $20,000 profit for the month, but the business checking account balance decreased by $5,000 during that same period. What is the most likely explanation?
- AThe contractor overpaid estimated taxes for the quarter
- BThe bookkeeper made an error recording payroll expenses
- CCustomers have not yet paid outstanding invoices, tying up cash in accounts receivable
- DThe company failed to use a job costing system
Show answer & explanationAnswer & explanation
Correct answer: C. Customers have not yet paid outstanding invoices, tying up cash in accounts receivable
Profit on the income statement is recorded when revenue is earned, not necessarily when cash is collected. If large invoices remain unpaid (accounts receivable), a company can show a profit while cash actually declines, especially if bills and payroll were paid in cash during the same period.
Why the other options are wrong
- A. Overpaying taxes would reduce cash but wouldn't explain a profit/cash mismatch of this size as the primary cause.
- B. A possible issue but not the most likely or common explanation for this pattern.
- D. Lack of job costing affects cost accuracy, not the direct profit-vs-cash timing gap.
Profit vs. Cash Flow
A company can be profitable on paper (accrual accounting) while still running short on cash due to timing differences between earning revenue and collecting payment.
- Accrual accounting records revenue when earned, not when paid
- Accounts receivable ties up cash until collected
- Cash flow problems are a leading cause of contractor business failure
Memory trick: Profit is on paper; cash is in the bank.