What Is a Transaction?
A transaction is a completed agreement between a buyer and a seller to exchange goods, services, or financial assets. But in business bookkeeping, this plain definition can get complicated. A transaction will be recorded earlier or later depending on whether the company uses accrual accounting rather than cash accounting.
- The accrual accounting method requires a transaction to be recorded when it occurs, regardless of when the money is received or the expenses are paid.
- The cash accounting method records a transaction only when the money is received or the expenses are paid. This may require a letter of intent or a memorandum of understanding.
Accrual accounting is used by businesses with gross receipts above $1 million a year, while the cash accounting method is used by most small businesses.
Understanding the Transaction
A sales transaction between a buyer and a seller is relatively straightforward. Person A pays person B in exchange for a product or service. When they agree on the terms, the transaction is complete.
Transactions can be more complex in the accounting world since businesses may make a deal today which won't be settled until a future date. Or, they may have revenues or expenses that are known but not yet due. Third-party transactions can also complicate the process.
Whether a business records income and expense transactions using the accrual method of accounting or the cash method of accounting affects the company’s financial and tax reporting.
- Accrual accounting recognizes a transaction immediately after it is finalized regardless of when payment is received or paid.
- Cash accounting records a transaction only when money is received or paid out.
- Cash accounting is used by most small businesses while accrual accounting is used by businesses with gross receipts above $1 million a year.
Using Accrual Accounting
When accrual accounting is used, a company records income when completing a service or delivering goods. If inventory is required when accounting for a company’s income, and the company has gross receipts above $1 million a year, the company normally uses the accrual method of accounting for sales and purchases.
Examples of Accrual Accounting
For example, a company selling merchandise to a customer on store credit in October records the transaction immediately as an item in accounts receivable. Even if the customer does not make a cash payment on the merchandise until December or pays in installments, the transaction is recorded as income for October.
If a customer buys something on credit, it will immediately be recorded as a transaction if the accrual accounting method is used.
The same goes for goods or services the company purchases. Business expenses are recorded when the products or services are received. Supplies purchased on credit in April are recorded as expenses for April, even if the business does not make a cash payment on the supplies until May.
Using Cash Accounting
Most small businesses, especially sole proprietorships and partnerships, use the cash accounting method. Income is recorded when cash, checks, or credit card payments are received from customers.
Examples of Cash Accounting
For example, a business sells $10,000 of widgets to a customer in March. The customer pays the invoice in April. The company recognizes the sale only after the cash is received in April.
Meanwhile, expenses are recorded only when a payment is made. For example, a business may purchase $500 of office supplies in May and pay for them in June. The business recognizes the purchase when it pays the bill in June.
For tax reasons, the cash basis of accounting is available only if a company has less than $1 million in sales annually. The cash basis is easier than the accrual basis for recording transactions because no complex accounting transactions, such as accruals and deferrals, are necessary. Its drawback is that the profit of the business may vary wildly from month to month, at least on paper.