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How Do Companies Record Business Transactions? (Part 1)
This video deals with how companies record the most common and important transactions (Part 1).
Hi and welcome to this video to the introduction to financial accounting course. Week 1 My name is Amedeo Pugliese. Yes. And I would be here to guide you through the slides which we would use throughout this week. In this session. We will go through the transactions that company engage into and how they account for these transactions with the idea that we will go through how financial statements look like at the end of the year. Let us start with the types of transactions a company engages with.
First, we distinguish financing transactions from operations within the financing transactions that are equity-related transaction which is what we call shareholders or own capital namely the resources that the owner of the company bring to the company itself. Secondly there is the debt, otherwise referred to as the third party financing. And you can think of it like something raising out of a relationship with the banks or other providers of resources. And then there are the operations. The operations are usually split in two main categories. One is the acquisition of products and services that will eventually generate expenses. And within this broad category we find basically three main items.
First one is the acquisition of long lived assets: think plant or machinery or equipment any item that will stay with the company for a long period of time. Long period of time meaning more than twelve months. Then there are the acquisitions of services like workforce or labor. And third the acquisition of raw materials and consumables that typically the company will employ throughout one cycle of production. And then the second group of operations are called sales which will eventually translate into revenues. And we distinguish the sales of products from the sales of services. Let us start with what is typically the first transaction companies engage with when they launch their operations.
Now imagine that we set up a new company which we call the work-for-less. And there are two investors two friends and they decide to launch these entrepreneurial activity by bringing each of them 50000 thousand to start up the company. How do we account for this transaction? If you can see here there are two different tables. The first one is focused on how we record the individual transaction. And the second one is something that we call statement-like. Now you have to bear with me for some time because it’s not a real financial statement but it is something that will help us getting there. But you have to be patient.
So, what we see here is an increase in cash that corresponds to an increase in equity by the same amount. And it is something you see in the very first row. What is different with the second grid and the second table. Well apparently nothing but it is only so because we are only looking at the first transaction. So if you look at what we have with transaction one you have on the left hand side an increasing cash that corresponds to the same increasing equity. Now bear in mind that this is an important property of accounting transactions. The two will always balance. Let’s move on to a second transaction. A second transaction relates to the acquisition of the workforce.
In order to launch their operations the two entrepreneurs hired two engineers and one expert in human relationship that will cost 16000 each year. What happens from an accounting point of view? Nothing. So there is no transaction that we can record because there hasn’t been any cash inflow or cash outflow as yet. You can imagine that this is like shaking hands and the employment relationship will start eventually but the payment of the salary will only happen later on. If you see the bottom part of the table you will see that it is identical to what we had in the previous slide. So we have cash for one hundred thousand. That corresponds to equity for 100000.
So no cash outflow no cash inflow. There is no accounting transaction to be recorded. Let’s move to a third operation. The company buy raw materials. So work-for-less spends 5000 and the payment is in cash. What’s happening here and let’s see what is reflected into the way we record the transaction. There is a decreasing cash for 5,000 which you will see on The right hand side that corresponds to an increase in the raw material for the same amount.
The key issue here is: has the company started using the raw materials? Well, in fact, no because the text is telling us That the company has both the raw material. So in essence the company is replacing cash with some material which will be eventually used later on in the production process. And this is what is reflected in the table in the bottom part of the where you can see that on your left hand side you have cash for ninety five thousand and raw materials for five thousand. That balance with the same amount of equity that is unaffected by this transaction which is worth one hundred thousand.
Be careful because next to each of the items you will see a number that corresponds to the number of the transaction which we are going to use. Let’s have a look at Operation number four. Work-for-Less starts up its operations and the appoint board members. Now these board members gather convene and start working now from an accounting point of view. There is no recording of any transaction. Why? Because there is no cash inflow nor cash outflow. This is no different from what we have seen in operation number two where the company hired two engineers and an HR manager. Well you may argue but these board members would not do it for free. You are right!
but you have to wait until these people would be paid out until you can actually record the transaction. And in fact if you look at the table in the bottom part of the slide this is not different from what we have seen in the previous slide and what we have cash for ninety five thousand raw materials for fact thousand which total one hundred thousand that corresponds to the same amount of equity on the right hand side. Operation number five the company engages into an acquisition of a long lived asset which is different from the acquisition of raw materials which we saw in transaction number three and the acquisition goes as follows.
Work-for-less makes a significant investment in a new plant and pays 60,000. No I shouldn’t say it pays sixty thousand because as part of the deal. Half of the money are paid in cash for thirty thousand and half are on credit. So they generate a bill, a payable. That will be settled in six months from now from an accounting point of view. This is a relevant transaction and that’s the way we recorded it. First, we write down that on April the 1st the value of the plant goes up by 60000 and this is on the left hand side of the upper table On the slide.
Whereas on the right hand side we see that there is a decrease in cash for 30000 and an increase in people for the same amount 30000. Now if are cognisant here you would realize and again the left hand side and the right hand side of the transaction the balance and the equal. In both cases sixty thousand. Now what happens in the bottom table in the bottom table we see that there is a decrease in the value of cash that goes from ninety five thousand to sixty five thousand. The raw materials stay at five thousand and there is an increase in the value plant because that’s what the company has now at its own disposal.
What happened on the right hand side?
Equity is unchanged: it is still there for a hundred thousand but then we realize that there is an increase in payable. A payable is a debt. It is a commitment to repay someone and that has a juridical value. Again, if you see the total value of the debt is higher than the right hand side of the column balance and the equal both to one hundred and thirty thousand let us know what the transaction number six this is again an acquisition of a long lived asset.
Work for less After attending a series of roadshows decides to make an investment to buy a new patent that will eventually allow extraction of cells with a non-invasive technique which is likely to generate future benefits for the firm. The expense is twenty thousand and the payment is in cash. Notice that it is a different case from what we have seen before because the payment is all in cash and there is no debt outstanding nor payable outstanding. How do we record these transaction efficiently upper part of the slide. The table tells us that there is an increase in the value of the patents for 20,000. That corresponds to a decrease in the value of cash for the same amount.
Remember, the two will always have to balance. When we look at the table in the bottom part of the slide we will see that the value of cash has gone down from sixty five thousand to forty five thousand to reflect the fact that the acquisition was paid in cash. The raw material is still there for five thousand. The plant is still there for sixty thousand and now we have a new patent which is a long lived asset it that is worth twenty thousand the total amount of what we call asset side.
But you have to bear with me is hundred and thirty thousand what we see on the right hand side of the table is unchanged vis a vis the previous slide because we have equity for 100,000 and payables for 30000. Let’s move on to a different transaction now which is the acquisition of workforce. Now if you remember the company hired engineers and the H.R. manager a while ago but it’s time to pay for their salaries. And in fact on July the 1st salaries are paid to the employees with a cash disbursement or a bank disbursement of eight thousand. Is this transaction relevant from an accounting point of view?
Yes it is because there is a cash outflow and in fact you will see that the upper table records exactly this transaction. There are salaries that go up by eight thousand. Correspondingly, there is a decrease in cash or a bank for exactly the same amount. And this is also reflected into the table at the bottom part of the slide. What you would see that cash has gone down from 45000 to 37000. And in the very last row of the table you would see that there are salaries that are recorded this transaction number seven for eight thousand. If you know this again the left hand side and the right hand side will balance again at one hundred and thirty thousand.
On July the 1st.
Works for less decides to buy health insurance for its own employees and pays 1000 for a 12 month premium: payment is in cash. Is this transaction relevant from an accounting point of view? Yes it is relevant because there is a cash disbursement and it is one of the key criterion to assess whether anything that happens in a firm is relevant from an accounting point of view or not. This is reflected into the way we record this transaction in the upper part of the table where you see that there is an increase in the insurance for 1000 that corresponds to a decrease in cash for 1000.
Companies engage in several types of transactions, from raising funds – through equity and debt – to making investments or purchasing goods or services and – hopefully – selling products and services. How do we record these transactions? Are all transactions relevant from an accounting point of view? Before watching the video, try to think about some important decisions or operations a company engages with, and try to guess whether it is relevant from an accounting perspective. A few hints may help: is hiring a CEO relevant? and buying a new plant? or investing into stocks of other companies? And purchasing a license?
The aim of this and the following video is providing you with an overarching logic to discern accounting relevant from irrelevant transactions.
You can find attached below the slides in pdf version we are presenting during the video.
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