In business, a transaction is an agreement between two parties– a buyer (the business itself) and a seller (a supplier or vendor). In a transaction, the seller supplies either goods, services or other financial assets in exchange for cash funds or credit.
Financial transactions are the lifeblood of a company, helping them to build a steady stream of revenue and facilitating cash flow. As well as the transactions between the business and its customers (B2C transactions), there will be many instances where the company will act as a buyer rather than a seller.
A company’s operating cash flow includes numerous transactions with third-party vendors. These may supply the goods that the company sells wholesale, or components/ingredients of products that the company makes. Alternatively, they may sell software or other goods and services that are required for business operations. These are known as B2B transactions. These cover general operational costs, as well as capital expenditures such as new equipment, machinery or plant that could enhance operations.
In business bookkeeping, it’s important to record different types of transactions accurately in order to ensure financial transparency, this plain definition of “transaction” can get tricky. Depending on whether the company uses cash accounting or accrual accounting, a transaction may be recorded earlier or later.
Types of transaction
There are several different types of financial transactions. While these are often considered interchangeable, each has its own meaning. They are as follows:
Sales- A sale is the legal transfer of ownership of property for either cash money or credit. This is what happens every time a customer pays for a product or service. Sales are then recorded on the balance sheet by extending credit to customers as accounts receivable
Purchases- Purchases involve the transfer of ownership of goods required for business operations from vendors. These may be paid for using either cash, credit accounts, or a combination of both. These are recorded as accounts payable
Receipts- These occur when a company receives money in exchange for providing goods or services to another company or entity
Payments- A payment is where one business entity pays another for the provision of goods or services
Examples of transactions
There are many exchanges that take place in business operations that meet the definition of a transaction. Some of the most common may include:
- Selling products or services to customers
- Borrowing start-up capital or bridging finance from a bank
- Paying employees, contractors, or subcontractors
- Paying for rent and utilities on a business premises
- Paying interest on the company’s liabilities
- Moving current assets from one department to another
These transactions are usually categorised as follows:
Cash and credit transactions
Typically, payment for a transaction is due immediately as cash. This helps companies to maintain liquidity. However, sometimes a company may extend credit to a customer in order to improve their brand value and take advantage of a sale that they may otherwise miss out on.
Internal and external transactions
Most transactions are external, meaning that they take place between the company and third parties like customers and suppliers. However, some transactions are internal such as the exchange of assets between departments or locations, or the payment of employees.
Business and investment transactions
As well as transactions related to business operations, a company may also make investments in marketable securities and other assets to generate income.
Accounting for business transactions
Whenever a transaction occurs, both the seller and buyer must make a record of it in their accounts.
There are two bookkeeping systems used to account for business transactions. These are cash accounting and accrual accounting.
The cash accounting method records transactions only when cash is received or paid by the company. Where funds are incoming they are recorded as revenue and outgoing funds are recorded as liabilities. The simplicity of cash accounting makes it popular for smaller businesses. In the UK, HMRC dictates that a company can only use this accounting system if their revenue is under £150,000.
Example of cash accounting
Fictional SME Nevrcrash Computers supplies 500 slim client PCs to a local high school for £1,000. The high school orders the computers on 28th of September and they arrive on 5th of October. The school pays for the computers upon delivery of the computers. As such, Nevrcrash records £1,000 in revenue on 5th of October when the computers were paid for rather than 28th of September when they were ordered.
The accrual method is slightly more complicated and often used by businesses with greater turnover. Here, revenues are recorded when they are earned, even if payment has yet to be received. Liabilities are also recorded when invoices are received and not necessarily when funds are transferred to the debtor.
Example of accrual accounting
Clothing wholesaler StitchUp receives an order from a high street retail chain for 10,000 t-shirts at £5 each on the 13th of January, and the retailer receives them 5 days later on the 18th. Because it uses the accrual method of accounting, it records the £50,000 in revenue on 13th January when the order was placed.
Likewise, on January 14th StitchUp receives an invoice from the manufacturer for the t-shirts (which it purchased for £2 each) which it settles on the 3rd of February. It records the liability of £20,000 on 14th January, even though it does not settle the invoice until almost a month later.
Frequently asked questions about transactions
What is a double-entry?
A double-entry system is a bookkeeping method where every transaction results in a credit to one account, and a debit to another. It is used to help prevent accounting errors and ensure that the company’s books are properly balanced.
What is an internal transaction?
An internal transaction involves the exchange of assets and funds within the business. For instance, the payment of employees is an internal transaction because funds are paid to an individual within the company in exchange for their labour.
What is a transaction device?
A transaction device is a means of making payment to facilitate the transfer of ownership of a product or service. Cash, credit cards, debit cards and company credit are all examples of transaction devices.
Which is the best accounting method for my small business?
Small businesses generally benefit from using the cash accounting method. It is relatively simple and easy to keep track of. It is also generally conducive to maintaining healthy cash flow which is extremely important for small businesses.
Do transactions contribute to a country’s GDP?
Although transactions are a significant contributor to a nation’s economy, they do not contribute to GDP. This is because no new wealth is generated by a transaction. It is simply a transfer of ownership of assets between different parties.