Accountants give similar accounting treatment to similar types of business transactions. Therefore, a first step in understanding financial reporting mechanics is to understand how business activities are classified for financial reporting purposes.
Business activities may be classified into three groups for financial reporting purposes: operating, investing, and financing activities.
Operating activities are those activities that are part of the day-to-day business functioning of an entity. Examples include the sale of meals by a restaurant, the sale of services by a consulting firm, the manufacture and sale of ovens by an oven-manufacturing company, and taking deposits and making loans by a bank.
Investing activities are those activities associated with acquisition and disposal of long-term assets. Examples include the purchase of equipment or sale of surplus equipment (such as an oven) by a restaurant (contrast this to the sale of an oven by an oven manufacturer, which would be an operating activity), and the purchase or sale of an office building, a retail store, or a factory.
Financing activities are those activities related to obtaining or repaying capital. The two primary sources for such funds are owners (shareholders) or creditors. Examples include issuing common shares, taking out a bank loan, and issuing bonds.
Understanding the nature of activities helps the analyst understand where the company is doing well and where it is not doing so well. Ideally, an analyst would prefer that most of a company’s profits (and cash flow) come from its operating activities. Exhibit 1 provides examples of typical business activities and how these activities relate to the elements of financial statements described in the following section.Exhibit 1. Typical Business Activities and Financial Statement Elements Affected
Accounting elements: Assets (A), Liabilities (L), Owners’ Equity (E), Revenue (R), and Expenses (X).
Not all transactions fit neatly in this framework for purposes of financial statement presentation. For example, interest received by a bank on one of its loans would be considered part of operating activities because a bank is in the business of lending money. In contrast, interest received on a bond investment by a restaurant may be more appropriately classified as an investing activity because the restaurant is not in the business of lending money.