Business Transactions
Basic Terminology for Accounting Information
Money resources and economic or service resources are the assets of a company. These sources of assets are known as the equities of a business. They represent claims upon the assets if the business is dissolved.
Expenses are the assets used up or spent to provide revenue. Revenue is the payment made by customers for the product or service purchased. Income is the excess of the assets received (revenue) over the assets used up to provide the revenue (expense); it is the net increase in assets. Income increases the owners' equity in the business because the owners' claim to assets is increased.
A distinct feature of traditional accounting information is that it relies heavily on a transfer or exchange between the business and outsiders and between areas within the company. Accountants tend to assume for recording purposes that an activity takes place when an exchange occurs. These exchanges are known as transactions.
Transactions
A transaction provides a means for measuring activity. By a transaction is meant the flow of economic resources, or rights to the resources, from one accounting entity to another.
Normally, some type of documentary evidence, such as a receipt or a signed authorization, arises at the time of a transaction. When this documentary paper exists, it is evidence of the existence of the transaction: with no documentary evidence, verification is more difficult. Nevertheless, if the significant activities are to be measured, the accounting process should provide a record of all transfers of rights ei-ther within the entity or between the entity and an outside group.
There are limitations to the transaction concept, for not all business activities are immediately reflected in a transaction. Specifically, changes in the market price of economic resources often occur without regard to business activities aimed at a future transaction.
Types of Transactions
The procedures of accounting largely represent means for measuring and communicating information on transactions. The development of these procedures involves problems of measuring and communicating information on three types of transactions. It is important to distinguish them, for different measurement and communication methods are appropriate for each type.
Future Transactions. By measuring and communicating information on possible future transactions, accounting reveals those activities which appear to be the most desirable for the entity to carry out in the future. By measuring and communicating information on planned future transactions, accounting reveals those actions which will have to be taken at appropriate times to carry out the plans most effectively. Accounting for possible future transactions may involve cost and revenue estimates for each proposal to indicate which machine should be acquired. Once a decision is made, a planned future transaction exists. Accounting for these planned future transactions involves relating them to each other so that a coordinated company plan results. Normally, they are grouped together in an operating budget to indicate when each planned transaction should take place.
Current Transactions. By measuring and communicating information on current transactions, accounting reveals the current state of the entity's activities. When these current transactions are compared with the budgeted or planned transactions, the information disclosed will enable management to take actions which will bring current activities in line with planned activities and thus control the activities of the entity.
Past Transactions. Measurement and communication of past transactions provide a description of the entity's activities over a period of time. Systematic study and analysis of these descriptions afford insights into the nature of an entity's operations which enable governments to establish tax collection methods, owners to control general managerial direction of the entity, and creditors to evaluate managerial performance over a period of time and in varying situations.
Classification of Transactions
Transactions may be classified in a number of ways. Possibly the most useful classification for accounting purposes is the following:
1. External transactions involve activities between an entity and someone outside the entity. They are of two main types:
a. Exchange transactions, wherein there is an exchange of economic resources or rights between the company or other entity and someone outside the entity, such as the sale of merchandise to a customer for cash.
b. Accrued transactions, wherein there is continuous gradual transfer or receipt of economic rights or services by the company to or from an outside party with the understanding that payment for the services will be made later. An example is the continuous transfer of electricity to a customer by an electric utility company, for which payment is made at the end of the month.
2. Internal transactions involve the activities within the company. These activities also are of two main types:
a. Transfer transactions, wherein there is a transfer of economic resources or rights from one area of the company to another in exchange for relief from responsibility for the resources or rights. The transfer of material from the storeroom to the factory is an example.
b. Accrued transactions, wherein the transfer of economic resources or rights is a continuous process. An example is the gradual using up of a machine over a period of time to make a product. The daily wearing out of the machine would be an accrued transaction.
Transactions and Accounting Data Collection Procedures
The study of accounting procedures is largely the study of means for collecting data on transactions. A record of data on past, present, and future transactions provides a means for describing business activities. Traditional accounting procedures normally measure transactions in terms of the monetary worth of the resources involved in the transactions. They provide for the classification of the transactions in such a way as to reveal the nature of the business activity involved.
Transactions and Business Activity
The validity of the assumption that business activities of all types ultimately result in transactions is most important to the double-entry recording process. If the «lag» between a business activity (e.g., making shoes for a customer) and the transaction (delivery of the shoes to the customer) were substantial, the criticism could be made that the accounting recording process is inadequate and should abandon the transaction concept.
To prevent the development of a «lag»'between a business activity and a transaction, accountants have defined a transaction in a special way: they have adopted the concept of an accrued transaction and use it to record business activity prior to the date the actual transaction occurs. There is apparently no limit to the use of the accrual concept; there are, however, certain conventions governing its use under the manual recording double-entry system. The concept of an accrued transaction as it is used for double-entry recording can best be explained by discussion of the four types of transactions.
External Exchange Transactions
The idea of an exchange, or a trading between two parties, underlies the concept of a transaction. While the description is satisfactory for most general purposes, for accounting purposes a transaction is defined in several special ways. One way, an external exchange transaction, refers to the exchange between the company and someone outside of the company.
External Accrued Transactions
The concept of an accrued (external) transaction, refers to those activities which result in a continuous transfer of services from one company to another.
Internal Transfer Transactions
To expand on the concept of internal transactions! note that it does not refer to an exchange with another company; it refers to the transfer of resources from one internal area to another internal area. Typically, internal transfer transactions refer to the transfer of resources from one department to another, or of responsibility for them from one person to another.
Internal Accrued Transactions
Internal accrued transactions represent the continuous transfer of resources from one area to another within the company. They are recognized periodically, generally at the end of each month, in the manually maintained accounting record.
Summary
Relying on the observation that business activities ultimately result in an exchange of some type, the accounting discipline for recording data on business activity uses the concept of a transaction to indicate when an activity has occurred.
As this chapter illustrates, a systematic recording of transactions by different recording processes provides a description of business activities. The transactions concept may also be used to describe future or planned activities and current or standard activities.
THE ANALYSIS OF FINANCIAL STATEMENTS
The objective of public accounting reports is to reveal or describe the economic activities of a company. The statements provide much useful information, but by analysis and study of them additional relationships and activities may be revealed The underlying principles of accounting analysis are to be found in information theory and communication theory.
The purposes for which information is needed will indicate the types of analyses to be made. In broad terms, there are three types of analyses:
1. General-purpose analysis, which aims merely to reveal more completely the information in accounting statements, and to relate to other factors in the company and the economy.
2. Analysis for credit or investment purposes, which aims to disclose relationships which bear upon the financial effectiveness of the company.
3. Analysis for management purposes, which aims to disclose successful and unsuccessful plans and operations.
Preliminary Arrangements
Regardless or the purpose for which an analysis is made, certain preliminary steps must be taken to arrange the data in suitable form. They include the following tasks:
1. Selecting and collecting relevant standards for evaluating an analysis.
2. Rounding off amounts, e.g., to the nearest hundreds or thousands of dollars.
3. Reclassifying accounts, especially if comparative statements over a period of time are used, so that a uniform classification will be used in all analyses.
4. In some instances, segregating and grouping accounts according to different classification systems.
5. Selecting, computing, and interpreting various statistical measures, economic indicators, ratios, comparisons, and relationships which reveal significant information.
Standards for Comparison. If comparative data are not available or cannot be developed, other analyses should be made for which comparative data will be available.
For every analysis, there should be some type of standard against which the resulting information may be compared. These standards may be:
1. Informal — sometimes only a «feeling» on the part of the reader of the analyzed data.
2. Past results against which current results may be compared.
3. Results of other companies in the same industry (there are a number of limitations to this type of standard, because companies are seldom entirely comparable).
4. Budgeted or planned standards reflecting the stated objectives of management before the period was started.
Rounded Dollar Valuation. Computations are made easier by rounding off all amounts in the statements to the nearest $1,000 ($100 for a small company). This step is important in that it calls attention to the generalized nature of many of the results of data developed by analysis, for analysis involves reducing a mass of information to a generalized figure. The greater the extent of this generalization the greater the danger of using one figure, such as a rate of return on total assets, to evaluate a company and its activities. However, since it is generalized information, it also represents useful information. Its usefulness, according to communication theory, derives from the human inability to comprehend in a significant manner a detailed mass of data.
Reclassification of Amounts. If analyzed data are to be compared, a uniform classification system should be used for all amounts compared.
In developing a uniform classification system, all offsets — where liabilities are reduced by assets so that only the net liability is reported, or vice versa — should be removed and all assets and liabilities revealed., In the same way, all reductions in liabilities and assets which have occurred should be recorded. Thus, treasury stock should not be treated as an asset but as a reduction in the stockholders' equity, because it is a reduction in an equity and not an asset. Also, bond discount should be deducted from the liability.
Classification for Different Purposes. For particular analyses, different classifications of amounts may be appropriate. It follows, that analyses to develop information useful for different purposes will require different aggregations of the ba-sic data.
Appropriate Ratios, Comparisons, Trends, and Relationships. The selection of the statistical measures, ratios, comparisons, trends, and relationships to be computed in analyzing statements and supporting data depends upon the specific purpose of the analysis. It is impossible to list all of the comparisons which may be made. Different situations and different purposes may require any number of different analyses. In general, the analyst should determine in detail the purpose for which the information is to be used before selecting the types of ratios and comparisons to be made.
Analysis for credit and investment purposes:
Typical analyses used in determining whether to loan or invest money in a company include:
1. Balance-sheet ratios.
2. Income-statement ratios.
3. Cross statement ratios.
4. Percentage statements.
5. Comparative statements.
Summary
The analysis of accounting reports is undertaken to achieve an understanding of a company and its activities. It is an involved process and the detailed study of this topic falls in the area of advanced accounting where statistical and mathematical methods and external, as well as internal, data are used. But this introduction to the subject provides a basic understanding of the process. It is based on the assumption that masses of data are often best understood when reduced to one significant figure. Consequently, a number of financial ratios may be used to reveal information in accounting reports. However, effective analysis of accounting reports can seldom be reduced to a process of computing 8 or 10 ratios. The more informative analyses depend upon the use that is to be made of the information. Broadly, accounting report analysis may develop information for either management or investors.
Effective analysis requires that the data available be unambiguously defined. Non-comparable data should be adjusted. If broad interpretations are to be made r data may be rounded off and reclassified to disclose only the significant information needed.
