Transactions in Bookkeeping and Those it affects
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.
Transactions are the lifeblood of every business, the heartbeat of activity that keeps it going. Understanding accounting, to a large extent, means understanding how accountants record the financial effects of transactions.
The financial effects of some transactions can be difficult to determine at the time of the original transaction because the outcome depends on future events that are difficult to predict. The financial effects of many transactions are clear-cut and immediate. On the other hand, figuring out the financial effects of some transactions is puzzling and dependent on future developments.
A business is a whirlpool of transactions; accountants categorize transactions into three basic types:
Profit-making transactions, which consist of revenue and expenses. Profit is the sum total of revenue for the period minus all expenses for the period.
Investing transactions, which refer to the acquisition of long-term operating assets such as buildings, heavy machinery, trucks, office furniture, and so on. Some businesses also invest in financial assets. 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.
Financing transactions, which refer to raising capital and paying for the use of the capital. 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 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. During the course of a year even a small business has thousands of revenue and expense transactions. In contrast, investing and financing transactions are generally low frequency. A business does not have a high volume of these types of exchanges with. transactions, except in very unusual circumstances.
A business is the hub of transactions involving the following persons and entities:
Its customers, who buy the products and services that the business sells. Also, a business may have other sources of income, such as from investments in financial assets (bonds, for example).
Its employees, who provide services to the business and are paid wages and salaries and provided with benefits, such as a retirement plan, medical insurance, workers’ compensation, and unemployment insurance.
Independent contractors, who are hired on a contract basis to perform certain services for the business. These services can be everything from hauling away trash and repairing plumbing problems to high-priced consultants who advise the business on technical issues to audits by a CPA firm.
Its vendors and suppliers, who sell a wide range of things to the business, such as products for resale, electricity and gas, insurance coverage, telephone and Internet services, and so on.
Government entities, which are the federal, state, and local agencies that collect income taxes, sales taxes, payroll taxes, and property taxes from or through the business.
Sellers of the various long-term operating assets used by the business, including building contractors, machinery and equipment manufacturers, and auto and truck dealers.
Its debt sources of capital, who loaned money to the business, charge interest on the amount loaned, and are due to be repaid at definite dates in the future.
Its equity sources of capital, the individuals and financial institutions that invest money in the business as owners and who expect the business to earn profit on the capital they invest.
Even a relatively small business generates a surprisingly large number of transactions, and all transactions have to be recorded. Certain other events that have a financial impact on the business have to be recorded as well. These are called events because they’re not based on give-and-take bargaining — unlike the something-given-for-something-received nature of economic exchanges.
Events such as the following have an economic impact on a business and are recorded:
A business may lose a lawsuit and be ordered to pay damages. The liability to pay the damages is recorded.
A business may suffer a flood loss that is uninsured. The waterlogged assets may have to be written down, meaning that the recorded values of the assets are reduced to zero if they no longer have any value to the business. For example, products that were being held for sale to customers (until they floated down the river) must be removed from the inventory asset account.
A business may decide to abandon a major product line and downsize its workforce, requiring that severance compensation be paid to the laid-off employees.