Transaction Definition

What Is a Transaction?

A transaction is a completed agreement between a buyer and a seller to exchange goods, services, or financial assets in return for money. The term is also commonly used in corporate accounting. In business bookkeeping, this plain definition can get tricky. A transaction may be recorded by a company earlier or later depending on whether it uses accrual accounting or cash accounting.

Key Takeaways

  • A transaction involves a monetary exchange for a good or service.
  • Transactions can be a little more tricky when it comes to corporate accounting.
  • Accrual accounting recognizes a transaction immediately after it is finalized, regardless of when payment is received or made.
  • Cash accounting is used mostly by smaller businesses and records a transaction only when money is received or paid out.
  • Third-party transactions can often complicate the process.

Understanding Transactions

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, money is exchanged for the good or service and the transaction is complete.

Transactions can be more complex in the accounting world because 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.

  • 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.

Whereas accrual accounting is used most often by businesses with an average of over $25 million over the prior three years, cash accounting is used primarily by small businesses.

Transactions Using Accrual Accounting

When accrual accounting is used, a company records income when completing a service or delivering goods. If an inventory is required when accounting for a company’s income and the company has gross receipts with an average of over $25 million over the prior three years, the company normally uses the accrual method of accounting for sales and purchases.

Examples of Accrual Accounting

A company selling merchandise to a customer on store credit in October records the transaction immediately as an item in accounts receivable (AR). 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.

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.

If a customer buys something on credit, it will immediately be recorded as a transaction if the company selling the good uses the accrual accounting method.

Transactions 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

Let's say 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. A business may purchase $500 of office supplies in May, for example, 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 an average of less than $25 million over the prior three years in annual sales. 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.

What Is an ACH Transaction?

An ACH transaction is an electronic payment made between banks. They are processed through the Automated Clearing House. Examples of ACH transactions include direct deposits for things like your salary or tax refund, and bill payments that are made online or through your bank.

How Do I Cancel a Pending Transaction?

Pending transactions are those that have been made but aren't posted to your account. These include payments, purchases, pre-authorized debits, and any other related transactions. Purchases made with a debit or credit card are held for a certain period of time before they work their way through the electronic system from your bank to the recipients. Contact the merchant and/or your bank to request a reversal if, for whatever reason, you want to cancel the transaction.

How Are Transactions Different in Accounting?

Accounting transactions are a little different because of the way they may be recorded. In the accrual method of accounting, transactions are recorded once they are executed. But in the cash accounting method, transactions are recorded only when money is received or paid.

The Bottom Line

A transaction signals a financial agreement between two parties where one benefits financially by selling goods and services to another. In simple terms, a transaction is completed when the goods and services change hands for money. But things get a little complicated when it comes to transactions in accounting. Businesses that use the accrual method of accounting record transactions when they are completed. In the cash method, they are documented only when payments are made or received.

Article Sources
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  1. Internal Revenue Service. "Publication 538 - Accounting Periods and Methods." Pages 8-9.