3 Types of Balance Sheet Transactions
Transactions change the makeup of a company’s balance sheet — that is, its assets, liabilities, and owners’ equity. The transactions of a business fall into three basic types. Notice that these three types match up with the three categories of cash flow in the statement of cash flows:
Operating activities: This category refers to making sales and incurring expenses, and also includes accompanying transactions that relate to the recording of sales and expenses.
For example, a business records sales revenue when sales are made on credit, and then, later, records cash collections from customers. The transaction of collecting cash is the indispensable follow-up to making the sale on credit.
For another example, a business purchases products that are placed in its inventory (its stock of products awaiting sale), at which time it records an entry for the purchase. The expense (the cost of goods sold) isn’t recorded until the products are actually sold to customers.
Keep in mind that the term operating activities includes the associated transactions that precede or are subsequent to the recording of sales and expense transactions.
Investing activities: This term refers to making investments in assets and (eventually) disposing of the assets when the business no longer needs them. The primary examples of investing activities for businesses that sell products and services are capital expenditures.
A capital expenditure is an amount spent to modernize, expand, or replace the long-term operating assets of a business. A business may also invest in financial assets, such as bonds and stocks or other types of debt and equity instruments. Purchases and sales of financial assets are also included in this category of transactions.
Financing activities: These activities include securing money from debt and equity sources of capital, returning capital to these sources, and distributing profit to owners. For instance, when a business pays cash dividends to its stockholders the distribution is treated as a financing transaction.
The decision whether or not to distribute some of its profit depends on whether the earnings generated are needed to operate the business. If the company distributes earnings by paying a dividend, the equity section of the balance sheet is reduced.