What is a Transaction?
A transaction is an agreement between a buyer and a seller to exchange goods, services or financial instruments.
In accounting, the events that affect the finances of a business must be recorded on the books, and an accounting transaction will be recorded differently if the company uses accrual accounting rather than cash accounting. Accrual accounting records transactions when revenues or expenses are realized or incurred, while cash accounting records transactions when the business actually spends or receives money. It may require a letter of intent or memorandum of understanding.
Transactions in terms of sales between buyers and sellers are relatively straightforward. Person A gives person B a certain amount of money for a good, service, or financial product.
Transactions can become more complex in the accounting world since businesses may sometimes make deals 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 occur. 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.
- Transactions are handled differently under different accounting systems.
- Accrual accounting recognizes a transaction upon delivery or invoice.
- Cash accounting records transactions when the payment is made or received.
Recording Transactions With Accrual Accounting
In accrual accounting, a company records income when completing a service or when shipping and delivering goods. If inventory is required when accounting for a company’s income, and the company typically has gross receipts over $1 million annually, the company normally uses the accrual method of accounting for sales and purchases.
Accrual accounting focuses on when income is earned and expenses are incurred. All transactions are recorded regardless of when cash is exchanged. For example, a company selling merchandise to a customer on store credit in October records the transaction immediately as an item in accounts receivable (AR) until receiving payment. Even if the customer does not make a cash payment on the merchandise until December, the transaction is recorded as income for October.
The same concept applies to goods or services the company buys on credit. Business expenses are recorded when receiving the products or services. For example, 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.
Recording Transactions With 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. 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 when the cash is received in April. Likewise, expenses are recorded when vendors and employees are paid. For example, a business purchases $500 of office supplies in May and pays for them in June. The business recognizes the purchase when it pays the bill in June.
The cash basis of accounting is available only if a company has less than $1 million in sales annually. Because no complex accounting transactions, such as accruals and deferrals, are necessary, the cash basis is easier than the accrual basis for recording transactions. However, the typically random timing of cash receipts and expenditures means reported results may vary between unusually high and low profits from month to month.