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.
Financing transactions refers 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 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.
Knowing who’s on the other side of transactions
Another way to look at transactions is to look at the counterparties of the transactions; this term refers to the persons or entities that the business enters into an economic exchange with. A business interacts with a variety of counterparties. 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 investments in financial assets (bonds, for example)
Its employees, who provide services to the business and are paid wages and salaries and are provided with benefits, such as retirement plans, 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 anything from hauling away trash and repairing plumbing problems to advising the business on technical issues and auditing 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 loan 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
Recording events
Certain other events that have a financial impact on the business have to be recorded as well. They’re 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.
As we explain in more detail in Chapter 3, at the end of the year, the accountant conducts a special survey to ensure that all events and developments during the year that should be recorded have been recorded so that the financial statements and tax returns for the year are complete and correct.
Taking the Financial Pulse of a Business
We devote a good deal of space in this book to explaining financial statements. In Chapter 2, we explain the fundamental information components of financial statements, and then Part 2 gets into the nitty-gritty details. Here, we simply want to introduce you to the primary kinds of financial statements so you know from the get-go what they are and why they’re so crucial.
The outside, nonmanager investors in a business receive summary-level financial statements. For example, investors see the total amount of sales revenue for the period but not how much was sold to each and every customer. Financial statements are based on the assumption that you, the reader, are not a manager of the business (see the earlier section “Recognizing users of accounting information”). The managers of the business should make good use of their financial statements, but they also need more detailed information beyond what’s in the business’s financial statements.
Meeting the balance sheet (statement of financial condition)
One type of financial statement is a “Where do we stand at the end of the period?” type of report. This is called the statement of financial condition or, more commonly, the balance sheet. The date of preparation is given in the header, or title, at the top of this financial statement. We present and explain a typical balance sheet in Chapter 2. Our purpose here is simply to present the basic content in a balance sheet.
A balance sheet summarizes the two opposite aspects
