Accounting For Dummies. John A. Tracy

cost of a product or in the purchase costs of products sold by retailers such as Costco and Walmart. Tracking costs is a major function of accounting in all businesses.

       Property accounting: A typical business owns many different substantial long-term assets that go under the generic name property, plant, and equipment — including office furniture and equipment, retail display cabinets, computers, machinery and tools, vehicles (autos and trucks), buildings, and land. Except for relatively small-cost items, such as screwdrivers and pencil sharpeners, a business maintains detailed records of its property, both for controlling the use of the assets and for determining personal property and real estate taxes. The accounting department keeps these property records.

       Tax compliance: The task of managing multiple tax accounting, reporting, and compliance functions usually falls on the shoulders of the accounting department. This extends well beyond simply completing annual income tax returns because most businesses must deal with a slew of other tax reporting and compliance matters, including sales/use, property, excise, payroll, and multiple other forms of taxation, at multiple levels including federal, state, county, local, and municipal.

       Liabilities accounting: An entity must keep track of all relevant details about every liability it owes — from short-term purchases on credit to long-term notes payable. No entity can lose track of a liability and not pay it on time (or negotiate an extension) without hurting its credit rating.

      

In most businesses and other entities, the accounting department is assigned other functions as well, but this list gives you a pretty clear idea of the back-office functions that the accounting department performs. Quite literally, a business could not operate if the accounting department did not do these functions efficiently and on time. And to repeat one point, to do these back-office functions well, the accounting department must design a good bookkeeping system and make sure that it’s complete, accurate, reliable, and timely.

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. 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 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. 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. We bring up this point 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.

      Separating basic 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. We explain earlier in this 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.

       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.

      

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. (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.

      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