Transactions that Drive the Balance Sheet - dummies

Transactions that Drive the Balance Sheet

A balance sheet is a snapshot of the financial condition of a business at an instant in time — the most important moment in time being at the end of the last day of the income statement period. The fiscal, or accounting, year of the business ends on December 31. So its balance sheet is prepared at the close of business at midnight December 31.

A company should end its fiscal year at the close of its natural business year or at the close of a calendar quarter — September 30, for example. This freeze-frame nature of a balance sheet may make it appear that a balance sheet is static. Nothing is further from the truth. The financial condition of a business is in constant motion because the activities of the business go on nonstop.

The activities, or transactions, of a business fall into three basic types:

  • Operating activities: This category refers to making sales and incurring expenses, and also includes the allied transactions that are part and parcel of making sales and incurring expenses. For example, a business records sales revenue when sales are made on credit, and then, later, records cash collections from customers.

    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) is not recorded until the products are actually sold to customers.

  • Investing activities: This term refers to making investments in assets and 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, which are the amounts spent to modernize, expand, and replace the long-term operating assets of a business.

  • Financing activities: These activities include securing money from debt and equity sources of capital, returning capital to these sources, and making distributions from profit to owners. Distributing profit to owners is treated as a financing transaction, not as a separate category.

The following is an example summary of changes in assets, liabilities, and owners’ equity during the year for a business example. Notice the middle three columns in the image, for each of the three basic types of activities of a business (described in the bullet list).

Summary of changes in assets, liabilities, and owners’ equity during the year.
Summary of changes in assets, liabilities, and owners’ equity during the year.

The image shown is not a balance sheet. Businesses do not report a summary of changes in assets, liabilities, and owners’ equity such as the one shown in the image. The purpose of the figure is to leave a trail of how the three major types of transactions during the year change the assets, liabilities, and owner’s equity accounts of the business during the year.

The summary of changes presented in the image gives a sense of the balance sheet in motion, or how the business got from the start of the year to the end of the year. It’s very important to have a good sense of how transactions propel the balance sheet.

A summary of balance sheet changes can be helpful to business managers who plan and control changes in the assets and liabilities of the business. They need a clear understanding of how the two basic types of transactions change assets and liabilities. Also, this summary of changes provides a useful platform for the statement of cash flows.