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.
In business bookkeeping, this plain definition of "transaction" can get tricky. A transaction may be recorded by a company earlier or later depending on whether it uses accrual accounting or cash accounting.
- A transaction involves a monetary exchange for a good or service.
- Accrual accounting recognizes a transaction immediately after it is finalized, regardless of when payment is received or made.
- By contrast, cash accounting, used mostly by smaller businesses, records a transaction only when money is received or paid out.
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 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
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). 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 company selling the good uses the accrual accounting method.
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.
Transactions Using Cash Accounting
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.