In understanding accounting, you need to be very clear about which classification of business transaction you’re looking at. Businesses are profit-motivated, so one basic type of transaction is obvious: profit-making transactions. In a nutshell, profit-making transactions consist of making sales and incurring expenses.
A business may have other income in addition to sales revenue, and it may record losses in addition to expenses. But the bread and butter profit-making activities of a business are making sales and keeping expenses under control. The profit-making transactions of a business over a period of time are reported in its income statement.
A business’s other transactions fall into three basic categories:
Set-up and follow-up transactions for sales and expenses: Includes collecting cash from customers after sales made on credit are recorded; the purchase of products (goods) that are held for some time before being sold, at which time the expense is recorded; and making cash payments for expenses some time after the expenses are recorded.
Investing activities (transactions): Includes the purchase, construction, and disposals of long-term operating assets such as buildings, machinery, equipment, and tools.
Financing activities (transactions): Includes borrowing money and repaying amounts borrowed; owners investing capital in the business and the business returning capital to them; and making cash distributions to owners based on the profit earned by the business.
Investing and financing activities of a particular period are reported in that period’s statement of cash flows. In contrast, set-up and follow-up transactions for sales and expenses stay in the background, meaning that they are not reported in a financial statement. Nevertheless, these transactions are essential to the profit-making process.
Consider, for instance, the purchase of products for inventory. As far as profit is concerned, nothing happens until the business makes a sale of that inventory and records the cost of goods sold expense against the revenue from the sale. Because the business needs to have the products available for sale, the purchase of inventory is the important first step, or set-up transaction.
