Focusing on Transactions
The recordkeeping function of accounting focuses on transactions, which are economic exchanges between a business or other entity and the parties with which the entity interacts and makes deals. A good accounting system captures and records every transaction that takes place without missing a beat. The financial effects of many transactions are clear-cut and immediate. This point is brought up because most people seem to think that accounting for transactions is a cut-and-dried process. Frankly, recording some transactions is more in the nature of “let’s make our best assessment, cross our fingers, and wait and see what happens.” The point is that recording the financial effects of some transactions is tentative and conditional on future events.
Distinguishing different types of transactions
A business is a whirlpool of transactions. Accountants categorize transactions into three broad types:
· Profit-making transactions consist of revenue and expenses as well as gains and losses outside the normal sales and expense activities of the business. It is explained earlier in the chapter that one way to look at profit is as an increase in retained earnings (surplus). Another way of defining profit is as the amount of total revenue for the period minus all expenses for the period. Both viewpoints are correct.
Included in this group of transactions are transactions that take place before or after the recording of revenue and expenses.
For example, a business buys products that will be held for future sale. The purchase of the products is not yet an expense. The expense is not recorded until the products are sold. The purchase of products for future sale must, of course, be recorded when the purchase takes place.
· Investing transactions refers to the acquisition (and eventual disposal) of long-term operating assets such as buildings, heavy machinery, trucks, office furniture, and so on. Some businesses also invest in financial assets (bonds, for example). These are not used directly in the operations of the business; the business could get along without these assets. These assets generate investment income for the business. Investments in financial assets are included in this category of transactions.
· Every business needs assets to carry on its operations, such as a working balance of cash, inventory of products held for sale, long-term operating assets (as described in the preceding bullet point), and so on. Broadly speaking, the capital to buy these assets comes from two sources: debt and equity. Debt is borrowed money, on which interest is paid. Equity is ownership capital. The payment for using equity capital depends on the ability of the business to earn profit and have the cash flow to distribute some or all of the profit to its equity shareholders.
Profit-making transactions, also called operating activities, are high frequency. (How many cups of coffee, for example, does your local coffee store sell each year? Each sale is a transaction.) In contrast, investing and financing transactions are generally low frequency. A business does not have a high volume of these types of transactions, except in very unusual circumstances.
Would you like to read more about this topic? This book might interest you: Accounting Fundamentals.